Statistically speaking, 2013 was a strange year indeed. The US reported very modest consumer price inflation of 1.5%, whereas the European Union and Japan came in even lower, at 0.86% and 0.36%, respectively. But during the same period, a painting by Francis Bacon called “Three Studies of Lucian Freud” sold for $142.4 million, the highest price ever paid for a painting at auction; a 59-carat diamond sold for $83.2 million, the highest price ever paid for a diamond at auction; trophy real estate prices in Manhattan, London, Sydney, and many other places soared past previous records; a limited-edition batch of Kentucky sour mash whiskey sold out at nearly $4,000 per bottle; and, of course, most developed-world equity markets marched in lockstep to new highs. ... The emergence of so many bubble-like niches in an ostensibly low-inflation world is curious. For instance, if the value of such major cur- rencies as the dollar and euro is stable, why were all these assets becoming so much more pricey? That is, after all, the same thing as saying that when valued in fine art or London penthouses, the world’s major currencies were actually plunging. Either those hot asset classes were simply random bits of foam in a vast, otherwise calm, disinflationary sea or the generally accepted definition of inflation is, in some fundamental way, flawed.
Having promised to do ‘whatever it takes’ to ensure the survival of the euro, the ECB now faces the problem of record high unemployment combined with a strong currency. There is accumulating evidence that the ECB is more willing to fight currency appreciation than the Bundesbank would have been. Capital inflows have been a key source of recent upward pressure on the euro. Should this continue, the ECB may need to intervene more aggressively in order to promote economic recovery in the Eurozone. ... as the currency continues to strengthen and moves into ‘strong territory’ relative to its history, the negative growth effects may eventually become intolerable. The basic challenge for the ECB is to ease overall financial conditions to the benefit of Eurozone growth. So far, easier credit conditions have pulled in foreign capital and caused the currency component of financial conditions to tighten. The ECB may need to enter the currency war more actively to secure a more competitive euro in 2014, and thereby support a more robust economic recovery.
Martin Feldstein interviewed Paul Volcker in Cambridge, Massachusetts, on July 10, 2013, as part of a conference at the National Bureau of Economic Research on “The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future.” Volcker was Chairman of the Board of Governors of the Federal Reserve System from 1979 through 1987. Before that, he served stints as President of the Federal Reserve Bank of New York from 1975 to 1979, as Deputy Undersecretary for International Affairs in the US Department of the Treasury from 1969 to 1974, as Deputy Undersecretary for Monetary Affairs in the Treasury from 1963 – 65, and as an economist at the Federal Reserve Bank of New York from 1952 to 1957. During the interludes from public service, he held various positions at Chase Manhattan Bank. He has led and served on a wide array of commissions, including chairing the President’s Economic Recovery Advisory Board from its inception in 2009 through 2011.
Market bubbles are called bubbles for good reason. They form, they inflate, they grow to an unstably distorted size, and ultimately they undergo the effects of rapid decompression in search of equilibrium. In a word … they pop. And generally speaking, the bigger the bubble the bigger the bang. … Most of us are pretty good by now, we think, at spotting bubbles. After all, we know what they look like; we recognize their characteristics, don’t we? Maybe. Maybe not. Not all bubbles look or act the same. … Is there a bubble inflating again? … people often shrug their shoulders, scratch their heads, and simply accept that there must be good reasons why stocks have been on a roll. The average investor, after all, is at least one step removed from the markets for intangible assets and therefore has comparatively little experience to help avoid becoming their occasional Venus flytrap dinner. … When it comes to assessing the state of the real economy, on the other hand, most people are more circumspect and not so easily taken in. … this bubble was born of desperation, first by the misguided monetary policy regime and then by investors who are sure to become its unsuspecting victims as they look for return—any return—in all the wrong places. … Railing against Fed policy, of course, doesn’t change it. … we continue to believe it is possible—and necessary—to see both the forest and the trees in order to fulfill our highest obligation: to continue acting in the best interests of our clients. As noted investment manager Francois Sicart said recently: “The attitude of many professional investors toward the current market makes me think of a crowd enjoying a dance party on top of an active volcano. They know it is going to erupt but, instead of planning an exit, they keep dancing while trying to guess the exact date and time of the eruption.”
As the world seems to be struggling back to its feet after the great financial crisis, I want to draw attention to an area we need to be concerned about: the conduct of monetary policy in this integrated world. A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially, as I will argue, and both advanced economies and emerging economies engage in it. Aggregate world demand may be weaker and more distorted than it should be, and financial risks higher. To ensure stable and sustainable growth, the international rules of the game need to be revisited. Both advanced economies and emerging economies need to adapt, else I fear we are about to embark on the next leg of a wearisome cycle. … The current non-system in international monetary policy is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing.
And as president and CEO of the Federal Reserve Bank of Dallas, Richard Fisher helps make the money go round. Meet the Fed’s most unlikely central banker. ... Fisher, it quickly became clear, also had a knack for colorful anecdotes, which he often drew from time spent on his ranch, in East Texas (the family leases out most of the grazing land but keeps a few dozen Longhorns for breeding purposes and rhetorical flair). A good example of this comes from a speech Fisher gave last year, in which he explained to a group of North Texas businessmen and women that his breeding bull, Too Big to Fail, has “plenty of liquidity at his disposal” but that the bull couldn’t do his job if there was a fence between him and the cows. American businesses, he continued, are faced with a fence of their own—a “fence of uncertainty.” The talk got a mixed reception. “Some people in Washington were aghast,” he told me later, but he had received a nice message from one of the cattle ranchers in the audience, who said that for the first time he understood monetary policy.
- The Fed is sending a message that the unwinding of its extraordinary accommodation will be done with great care and patience, and will take time – a long time.
- In delaying a taper, not only did the Fed show markets it has little tolerance for any tightening of financial conditions, it also strengthened its forward guidance considerably.
- The Fed’s decision to delay a taper will likely relieve some of the upward pressure on longer-term interest rates.
Is the new central-bank governor’s optimism warranted? … WHEN Mark Carney was governor of the Bank of Canada he made a habit of warning his compatriots that a day of reckoning was coming if they did not stop piling up debt. The central bank would not keep interest rates low forever. Eventually the overnight rate would rise from 1%, where it has been since 2010, putting pressure on indebted Canadians. ... Mr Carney is now grappling with Britain’s overleveraged consumers. His successor at the Bank of Canada, Stephen Poloz, has been delivering a cheerier message since he took over in June, even though household debt and house prices are at record levels (see chart). He has expressed confidence that Canadian consumers are doing the arithmetic in order to manage their debts, and looks forward to the day when exports and investment drive economic growth. Has the situation changed, or just the man?
In this essay I want to build on some of the ideas that were developed in my last essay specifically as they pertain to thinking about asset markets. The most obvious place to start is with the idea that the natural rate of interest is a myth. Accepting this idea has many ramifications for the way in which one conducts asset pricing. ... Perhaps the clearest implication from my previous essay with respect to investing is that the cash rate is potentially unanchored. That is to say, without a natural rate it isn’t obvious what cash rate one should expect to see in the long term. ... If, like any number of my colleagues, you don’t believe a word I’ve written (and quite possibly think that I either have escaped from or belong in an asylum), then let me leave you with one last chart. Even if you believe that real interest rates do matter for equity market valuations, and, hence, that lower real rates justify higher sustainable levels of P/E, you still need to ask yourself the following question: Would I need to believe that today’s U.S. equity market valuations represent fair value?
So the Fed has chosen to hold off on their goal of normalizing interest rates and the ECB has countered with the threat of extending their scheduled QE with more checks and more negative interest rates and the investment community wonders how long can this keep goin’ on. For a long time I suppose, as evidenced by history at least. ... zero bound interest rates destroy the savings function of capitalism, which is a necessary and in fact synchronous component of investment. Why that is true is not immediately apparent. If companies can borrow close to zero, why wouldn’t they invest the proceeds in the real economy? The evidence of recent years is that they have not. Instead they have plowed trillions into the financial economy as they buy back their own stock with a seemingly safe tax advantaged arbitrage. But more importantly, zero destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society. These assumed liabilities were based on the assumption that a balanced portfolio of stocks and bonds would return 7-8% over the long term. Now with corporate bonds at 2-3%, it is obvious that to pay for future health, retirement and insurance related benefits, stocks must appreciate by 10% a year to meet the targeted assumption. That, of course, is a stretch of some accountant’s or actuary’s imagination.
How will negative interest rates change the rules of the game for investors and policymakers? ... Traditional economic theory says that a com - bination of massive deficit spending and histori - cally low (not to mention negative) interest rates should produce a rip-roaring boom in which work - ers get generous raises, prices spike, and interest rates follow. Theory also says that, even in the rare case of nominal interest rates turning neg - ative, the rates can’t stay there because beyond this “zero bound,” savers and investors will with - draw their cash and store it themselves, emp - tying banks and crashing the financial system. ... Multiple factors provide possible explanations for this curious situation. Three in particular stand out: demographic changes, the impact of debt burdens, and uncertain implications of monetary policy (especially quantitative easing). ... In a June 2015 report, the Bank for Interna - tional Settlements echoed this sentiment by con - cluding that a policy of persistently low interest rates “runs the risk of entrenching instability and chronic weakness.” Such an environment makes several extreme—and, sometimes, mutu - ally exclusive—scenarios at least conceivable.
My point is different. Low interest rates for an extended period of time don’t damage economic growth directly, but they cause damage in a multiple of other ways – a point almost universally missed by the critics. That is what this month’s Absolute Return Letter is all about. ... central bank action has had the effect of de-linking equities from the global growth cycle, as equity investors have chosen to blatantly ignore the fall in global trade in favour of more risk-taking at the back of accommodating central banks. Risk-on, risk-off has miraculously turned into risk-on, risk-on. “Don’t fight the Fed”, as they say, and equity investors have obviously chosen not to. ... First and foremost, returns are going to remain subdued because GDP growth will stay low for a long time to come. Demographic factors, productivity factors and mountains of debt in the majority of countries all point in the same direction, and that is towards below average economic growth. ... The most structural of those factors – demographics – will remain a negative for the U.S. economy for another 10-15 years, whilst economic growth in the euro zone and Japan will be negatively affected by demographics until at least 2050. This does not imply that there cannot be extraordinarily good years every now and then, but the average growth rate will almost certainly be low, causing interest rates to stay relatively low for a lot longer than most expect and corporate earnings to disappoint as well.
Today we have the highest living standards in human history that co-exist with an ability to destroy our planet ecologically and ourselves through nuclear war. We are in the greatest period of stability with the largest probabilistic tail risk ever. The majority of Americans have lived their entire lives without ever experiencing a direct war and this is, by all accounts, rare in the history of humankind. Does this mean we are safe from the risk of devastating conflict on our own soil? ... Peace has a dark side. Peace can exist due to hidden conflict in the Prisoner’s Dilemma. ... Global Capitalism is trapped in its own Prisoner’s Dilemma; forty four years after the end of the Bretton Woods System global central banks have manipulated the cost of risk in a competition of devaluation leading to a dangerous build up in debt and leverage, lower risk premiums, income disparity, and greater probability of tail events on both sides of the return distribution. Truth is being suppressed by the tools of money. Market behavior has now fully adapted to the expectation of pre-emptive central bank action to crisis creating a dangerous self-reflexivity and moral hazard. Volatility markets are warped in this new reality routinely exhibiting schizophrenic behavior. The tremendous growth of the short volatility complex across all assets, combined with self-reflexive investment strategies, are creating a dangerous ‘shadow convexity’ that will fuel the next hyper-crash. Central banks in the US, Europe, Japan, and China now own substantial portions of their own bond or equity markets. We are nearing the end of a thirty year “monetary super-cycle” that created a “debt super-cycle”, a giant tower of babel in the capitalist system. As markets now fully price the expectation of central bank control we are now only one voltage switch away from the razors edge of risk. Do not fool yourself - peace is not the absence of conflict – peace can exist on the very edge of volatility. ... Since 2012, the Federal Reserve have been engaged in a pre-emptive war against financial risk, and other central banks are forced to follow suit in a self-reinforcing cycle of devaluation and a mad game of Prisoner’s Dilemma. This unofficial, but clearly observable policy has the unintended consequence of socializing risk for private gain and introduces deep ‘shadow’ risks in the global economy. ... At this stage, absent continuous intervention, a large deflationary crash in the global economy is inevitable. The greatest risk is that if central banks continue a policy of competitive devaluation and hyper-asset bubbles the end result will be an even more devastating crash, followed by sovereign defaults, and then class warfare. The next Lehman brothers will be a country. The real ‘shadow convexity’ will not come from markets but political unrest or war. ... History shows us that economic recovery from a depression has never been successfully engineered without major debt reduction, devaluation, default, hyperinflation, political revolution, or world war.
Future business activity will reflect two economic realities: 1) the over-indebted state of the U.S. economy and the world; and 2) the inability of the Federal Reserve to initiate policies to promote growth in this environment. ... The first reality has been widely acknowledged, as developed and developing countries both have debt-to-GDP ratios sufficiently large to argue for a slowing growth outlook. ... The second economic reality is the failure of the Federal Reserve to produce economic progress despite years of wide-ranging efforts. The Fed’s zero interest rate policy (ZIRP) and quantitative easing (QE) have been ineffectual, if not a net negative, for the economy’s growth path. ... The evidence speaks for itself: the Fed cannot print money. The Fed does not have the authority or the mechanism to print money. They have not, they are not and they will not print money under present laws.
Famous German soccer coach Sepp Herberger once said, “After the match is before the match.” The same can be said for financial markets: After the crisis is before the crisis. The complication, of course, is that while soccer players usually know exactly when the next match will kick off, the timing of the next crisis is always uncertain for financial players. All we know is that, eventually, there will be another one. ... What’s perhaps less obvious is that the global savings glut also helps to explain the occurrence of financial bubbles and subsequent crises of the past few decades. ... the global savings glut plays an important role in explaining this evidence. How? Excess savings not only pushed down r* and actual interest rates but also drove up asset prices and caused serial asset bubbles in equities, emerging markets, housing, credit, eurozone peripheral bonds and commodities. Whenever a bubble burst, it sparked financial distress and crisis. ... there is a feedback loop between financial crises and the savings glut. This is because a financial crisis and the related destruction of wealth leads to even higher desired saving (or deleveraging), and because the depressing impact on growth reduces investment and thus the demand for savings. ... now that exhaustion has set in almost everywhere for many unconventional policy tools, such as quantitative easing, there is a significant risk that central banks may not be able to deal effectively with the next crisis. ... It’s likely the only viable way out would be a joint effort by the major countries to raise public spending on infrastructure, education, and more in order to absorb excess savings and raise r*.
Given the importance of spillovers from monetary policies, especially in the face of globally low inflation, it is important we start building a global consensus on how to get better outcomes for the world. Nevertheless, with economic analysis of these issues at an early stage, it is unlikely we will get strong policy prescriptions soon, let alone international agreement on them, especially given that a number of country authorities like central banks have explicit domestic mandates. ... This paper therefore suggests a period of focused discussion, first outside international meetings, then within international meetings. Such a discussion need not take place in an environment of finger pointing and defensiveness, but as an attempt to understand what can be reasonable, and not overly intrusive, rules of conduct. ... As consensus builds on the rules of conduct, we can contemplate the next step of whether to codify them through international agreement, see how the Articles of multilateral watchdogs like the IMF will have to be altered, and how country authorities will interpret or alter domestic mandates to incorporate international responsibilities. ... The international community has a choice. We can pretend all is well with the global financial non-system and hope that nothing goes spectacularly wrong. Or we can start building a system for the integrated world of the twenty first century.
As we have observed in the past, financial markets appear to solely focus on one major risk/return catalyst at any given time, before, like a bored teenager, turning attention to the “next new thing.” Over the past year and a half, we have seen primary market focus transition from the dramatic decline in oil prices, to economic stresses in China, and most recently to the forthcoming referendum in the United Kingdom and the possibility of “Brexit.” We are not for a moment suggesting that these factors are unimportant, as indeed they are all critical parts to a broader puzzle, but we would suggest that stepping back to apprehend the full image on the puzzle is vital when too many market participants are overly focused on one part of it. In fact, we think that such an overly limited focus in a world of complex market crosscurrents may be part of what leads many to underperform. To that end, we seek to take a broader view with our market outlook. ... In this edition of the outlook we begin by sorting through and evaluating some partial market myths that have recently been promulgated to explain market volatility. These include exaggerated concerns that the volatility is due to bond market illiquidity, or overdone assertions that markets are being driven higher and lower primarily on the back of oil price movements. Rather, we think that secular structural changes involving demographic trends and profound technological innovations are much more important considerations when judging those forces that are truly impacting economic and asset valuation dispersions. Further, we believe these secular challenges should also be the focus of the risk factors that represent the major fault lines in markets today, or the locations of potentially serious left tail risks.
- Also: Project Syndicate - The Fear Factor in Global Markets < 5min
- Also: Financial Times - Central banks prove Einstein’s theory < 5min
- Also: Wall Street Journal - The High Consequences of Low Interest Rates < 5min
- Also: CFA Institute - Policy Divergence and Investor Implications 5-15min
- Also: Bloomberg - Japan Negative Rates Alchemy Beats Australia's Highest AAA Yield < 5min
At some point towards the middle of the decade, shortly before the cult of the expert smashed into the populist backlash, the shocking power of central banks came to feel normal. Nobody blinked an eye when Haruhiko Kuroda, the head of Japan’s central bank, created money at a rate that made his western counterparts seem timid. Nobody thought it strange when Britain’s government, perhaps emulating the style of the national football team, conducted a worldwide talent search for the new Bank of England chief. ... nobody missed a beat when India’s breathless journalists described Raghuram Rajan, the new head of the Reserve Bank of India, as a “rock star”, or when he was pictured as James Bond in the country’s biggest business newspaper. ... The key to the power of the central bankers – and the envy of all the other experts – lay precisely in their ability to escape political interference. ... The call to empower experts, and to keep politics to a minimum, failed to trigger a clear shift in how Washington did business. But it did crystallise the assumptions of the late 1990s and early 2000s – a time when sharp criticisms of gridlock and lobbying were broadly accepted, and technocratic work-arounds to political paralysis were frequently proposed, even if seldom adopted. ... If the clashes of abstractions – communism, socialism, capitalism and so on –were finished, all that remained were practical questions, which were less subjects of political choice and more objects of expert analysis. ... Greenspan’s genius was to combine high-calibre expert analysis with raw political methods. He had more muscle than a mere expert and more influence than a mere politician. The combination was especially potent because the first could be a cover for the second: his political influence depended on the perception that he was an expert, and therefore above the fray, and therefore not really political.
It’s been six years since we first wrote about the coming G-Zero world—a world with no global leader. The underlying shifts in the geopolitical environment have been clear: a US with less interest in assuming leadership responsibilities; US allies, particularly in Europe, that are weaker and looking to hedge bets on US intentions; and two frenemies, Russia and China, seeking to assert themselves as (limited) alternatives to the US—Russia primarily on the security front in its extended backyard, and China primarily on the economic front regionally, and, increasingly, globally. ... These trends have accelerated with the populist revolt against “globalism”—first in the Middle East, then in Europe, and now in the US. Through 2016, you could see the G-Zero picking up speed ... with the shock election of Donald Trump as president of the US, the G-Zero world is now fully upon us.
1. Independent America: Trump rejects the comparative weakness of the presidency, and he wants to more directly project American power in service of US national interests
2. China overreacts: Xi will be extremely sensitive to external challenges to his country’s interests at a time when all eyes are on his leadership
3. A weaker Merkel: Could the Europeans have resolved their financial crises without the Germans forcing a solution?
4. No reform: The reform needle won’t move in 2017. Save for a few bright spots, money won’t know where to flow
5. Technology and the Middle East: Technology, a force for economic growth and efficiency, also exacerbates political instability
6. Central banks get political: In the US, there’s risk of an open conflict between the Federal Reserve and the White House
7. The White House versus Silicon Valley: Technology leaders from California, the major state that voted in largest numbers against Trump in the election, have a bone to pick with the new president
8. Turkey: Ever-fewer checks on executive power will leave the private sector vulnerable to political whims
9. North Korea: It’s making consistent progress on an intercontinental ballistic missile capability that would allow it to hit the West Coast of the US with a nuclear weapon
10. South Africa: South Africa’s political infighting will undermine the country’s traditional role as a force for regional security
Red Herrings: US domestic policy, India versus Pakistan, Brazil
Two groups of true believers are driving changes in the developed world. The first: single-minded central bankers who spent trillions of dollars pushing government bond yields close to zero (and below). While this unprecedented monetary experiment helped owners of stocks and real estate, its regressive nature did little to satisfy the second group: voters who are disenfranchised by globalization and automation, and who are on the march. What next? The fiscal experiments now begin (again). ... why do we see 2017 as another year of modest portfolio gains despite the length of the current global expansion, one of the longest in history? As 2016 came to a close, global business surveys improved to levels consistent with 3% global GDP growth, suggesting that corporate profits will start growing at around 10% again after a weak 2016. More positive news: a rise in industrial metals prices, which is helpful in spotting turns in the business cycle ... Furthermore (and I understand that there’s plenty of disagreement on the benefits of this), many developed countries are transitioning from “monetary stimulus only” to expansionary fiscal policy as well. Political establishments are aware of mortal threats to their existence, and are looking to fiscal stimulus (or at least, less austerity) as a means of getting people back to work. The problem: given low productivity growth and low growth in labor supply, many countries are closer to full capacity than you might think. If so, too much fiscal stimulus could result in wage inflation and higher interest rates faster than you might think as well. That is certainly one of the bigger risks for the US.
The regulator closed almost 100 banks in 2016, and in a cleanup with few precedents, Nabiullina has shut almost 300 over the past three years. This may be only the beginning. There are about 600 banks left across the world’s largest country, but Fitch Ratings analyst Alexander Danilov, adjusting for population, calculates that as an emerging market Russia would be fine with about 1 in 10 of those. ... she runs what in Russia is called a “megaregulator.” When it comes to the economics behind Putin’s overarching goal of restoring Russia’s place in the world, there’s no one more influential. ... As central bank governor, she’s in charge of a banking system whose weak links are an economic burden, driving up the cost of financing so badly needed in the face of stagnant growth. She’s also the chief guardian of Russia’s foreign currency reserves. Those holdings are more than just a tool of monetary policy; according to several senior officials, Putin views them as a vital safeguard of the country’s sovereignty. ... The full picture only becomes clear when they’re shut down and regulators have to track the assets. In those cases, only about 40 percent of what the banks claimed was on their books actually existed
The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood. ... To re-establish a shared understanding, we will need to reassess both the imperatives that justified the extraordinary actions and the imperatives about monetary policy that were claimed. This will require candidly acknowledging the uncertainty associated with the transmission mechanism and the challenge of decision-making in conditions of uncertainty. ... It appears to me that the Fed and other central banks have avoided being candid about the uncertainty in order to maintain their credibility. I think this is backwards. Central banks cannot and will not regain their credibility unless they are candid about the uncertainty and how they confront that uncertainty.
- Also: Financial Times - US Treasuries: On the cusp of a reversal < 5min
- Also: FiveThirtyEight - The Fed’s Favorite Inflation Predictors Aren’t Very Predictive < 5min
- Also: Absolute Return Partners - A Note on Inflation: Is it here or isn’t it? 5-15min
- Also: Janus - Show Me The Money < 5min
- Also: Financial Times - Three ways the economic and financial cycle could end < 5min