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Friday
Dec132013

Euro starting to weigh on corporate profitability

Bloomberg has a good story this morning on how a strong euro is now forcing automakers such as Peugeot and Fiat to cut their year-end profit targets. Nothing is ever easy is it? European growth improves and now a strong euro might kick things into reverse. The ECB should take note. Europe is becoming Japan and the periphery is paying the price (deflation) for the its reward (a balanced or even positive current account). However, this position will consistently come under pressure if and when the EUR appreciates.

Expect the ECB to start leaning against this.

We have a small comment up on this over at Variant Perception's blog.

There is an interesting story this morning on Bloomberg about the travails of European automakers and the strong euro. According to Bloomberg, the already troubled French automaker Peugeot will take a €1.1 bn non-cash charge due to adverse currency fluctuations in Russia and Latin America. In Italy, the country’s biggest automaker Fiat has cut its year-end profit target by  13% to take into account currency movements. 

Nothing comes for free and with the eurozone periphery deflating its way to a currency account surplus the aggregate external balance of the euro area has increased to its highest level ever at more than 2% of GDP. Coupled with tighter liquidity (less euros sloshing around), improved sentiment and repatriation ahead of AQR* the EUR has seen strong support this year.

Monday
Nov252013

Paging Krugman: The paradox of thrift is global

"In a liquidity trap, saving is a personal virtue but a social vice", Paul Krugman 2013

Paul Krugman is annoyed with Summers for taking his ideas of a permanent liquidity trap to market (in this case the intelligentsia at the IMF). I think he will be alright in the end though. What consequently could have gone into the ether as a relatively innocuous speech has fast developed into a new economic manifest spear headed, as it were, by Krugman. The gist of the message is the notion of a permanent slump as argued here in a NYT oped. The best quote to capture this "new" idea is the following from Krugman; 

Larry’s formulation of our current economic situation is the same as my own. Although he doesn’t use the words “liquidity trap”, he works from the understanding that we are an economy in which monetary policy is de facto constrained by the zero lower bound (even if you think central banks could be doing more), and that this corresponds to a situation in which the “natural” rate of interest – the rate at which desired savings and desired investment would be equal at full employment – is negative.

And as he also notes, in this situation the normal rules of economic policy don’t apply. As I like to put it, virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment, thanks to the paradox of thrift. Fixating on debt and deficits deepens the depression. And so on down the line.

Allow me initially to dispense with the deeply partisan argument hidden in all this. The Austrians and blood letters are evil, austerity and prudence are folly and rapidly rising debt as a proportion of national income is not a problem (on the contrary, it is needed!). This is all a boring and predictable part of the argument, but there are aspects of this new "meme" which are really, really important to consider. I take three points from this discussion which closely links to my own work.  

  • Demographics are pushing OECD economies into a collective liquidity trap - Ageing populations are pulling us towards a negative natural level of interest. This suggests that liquidity traps and ZIRP are now the new normal. Trend growth and interest rates fall with population ageing and when working age population growth turns deeply negative so does trend growth and the natural rate of interest. 
  • Global paradox of thrift - If more and more economies are now faced with a negative natural rate of interest it means that (desired) savings will exceed investment even with ZIRP. This has crucial implications for global capital flows. You only need rudimentary algebra to see this in the context of basic national accounting. If S>I it can only mean that the current account is positive in an open economy and this is difficult to prescribe a universal growth strategy since you need someone to run the deficits.  
  • The economy needs persistent asset bubbles to sustain full employment - This is Krugman's defense for ultra loose monetary policy (in the US) and I think it is a poor one. If the liquidity trap is the new normal it also stands to reason that the extraordinarily loose monetary policy normally associated with a such a situation becomes endemic and structural. Asset prices buoyed by easy money from the Fed simply becomes a necessity to close the output gap. As I argue below I think this is a tenous argument at best. 

If Krugman is annoyed with Summers then I am annoyed with both of them. First of all, they are putting their weights behind ideas that Edward and I have been arguing for a while now (5 years to be exact). This is a small part of my nuisance though. Professional jealousy is not my forte. I am interested in ideas, particularly good ones, and the ideas being crystallised here by Krugman and Summers are really important ones.

What annoys me more is that I am not sure this applies to the US economy at all. We should note here that US working age population is set to be positive for many decades still while it is now negative as far as the eye can see in Japan and Europe. Why haven't someone in the ECB thought up these ideas I ask?!

As such I think this is a very poor argument for continuing loose Fed policy. It should be clear by now that QE has substantial negative externalities one of which is of course the emergence of asset price bubbles which inevitably burst. The financial market can be an evil mistress and it is often the very people the Fed is supposed to create jobs for that lose out spectacularly when parabolic upward moves in equities turn into gut wrenching declines. In addition and while I must admit I can only point to anecdotal evidence I think that the aggressive QE has damaging income redistributive effects and essentially that it fosters income inequality. 

On the other hand I think the realisation that more and more economies are now being stuck at the zero lower bound and what it means for desired savings is absolutely crucial. This means that desired savings in the OECD is now structurally above investment demand which puts tremendous pressure on the equilibrium game that is ultimately global capital flows.

I think this is the critical research paradigm that must be taken from this discussion and not whether aggressive monetary policy in the US is appropriate. I actually think it might not be and in any case I think the real examples of this important new theoretical postulate should be found outside the US. 

Monday
Nov182013

Should the Fed move further down the rabbit hole?

Taper mania remains high as ever with the market trying to figure out when, how fast and indeed in what direction the Fed will choose to adjust its asset purchase programme. In particular, the possible combination of an extension of forward guidance coupled with tapering in 1Q13 is slowly emerging as the consensus, but there are a lot of US data points to contend with from here to there. 

Meanwhile, a note last week by Morgan Stanley points to the increasingly market distorting effect the Fed is having on the MBS market.

In the first instance, it is interesting to note MS's interpretation of the Fed's view on MBS purchases as a key instrument in the monetary transmission mechanism from QE to the real economy. 

The FOMC has made clear that while purchases of Treasuries are not an academic “best practice,” it does believe that MBS purchases directly support the housing recovery. In her hearing, Yellen stressed that lower mortgage rates have been the “positive factor in generating the recovery of the housing sector.” She also reiterated that the sharp increase in mortgage rates over the summer played a role in the Committee's decision not to taper at its September meeting.

Morgan Stanley, November 15th, p. 2

Personally, I am skeptical that it was really the back-up in long rates which delayed tapering in September; I think was the fact that short rates were also starting to move. This then represented a direct attack on forward guidance which was effectively an attack on the Fed's ability to set short term rates. There was no way that the Fed could let this happen and also one of the reasons I think that Yellen intends to implement an even more aggressive forward guidance. My guess is that she is playing with fire here boxing herself in to conduct a dog fight with the market on the course of short term interest rates as far ahead as 2-3 years.

For those who are calling for the Fed to extend forward guidance under the guise of Yellen's optimal control framework, consider the following question. Could the yield curve invert under forward guidance?

I will leave that question to simmer a bit. 

Another point is that the notion of MBS purchases as strong support for the housing recovery. This is an increasingly difficult argument to make in my view. There are two reasons for this. First of all, new mortgage origination in the US has not made a rebound after the crisis with consumers essentially suggesting that the Fed is pushing on a string with its MBS purchases. This is to say that while it may help to keep long rates lower it has done little to increase new mortgage borrowing. 

Secondly as MS shows, the Fed's involvement in the MBS market is becoming systemic just at a time when the Federal government is trying to rid itself of mortgage market involvement through GSE (government sponsored entities). 

(...) there are stock-based and flow-based constraints the Fed will have to bear in mind. Since the beginning of MBS purchases under “QE3”, Fed holdings as a percent of total MBS outstanding have increased rapidly to about 26 percent. Every month of $40 billion (net basis) in MBS purchases increases the Fed holdings as a percentage of total MBS outstanding by about 0.8 percentage points. Even if the Fed were to taper MBS beginning in March and complete purchases by the end of 2014, Fed holdings of MBS would rise to 34% of the total MBS market.

A key question, then, is how much of total outstanding MBS does the Fed want to hold; at what point is it too high? Flow-based constraints have also become more of a risk following the drop-off in refinancing over the summer. Agency MBS production has now fallen to $70-$80 billion per month with the Fed buying $53 billion per month ($40 billion in QE and $13 bn in reinvestment). A compelling argument can be made that this would be considered a market-distorting share.

Morgan Stanley, November 15th, p. 3

I think MS is being diplomatic here. It is now abundantly clear that the Fed is having a market distorting effect on the MBS market. This would favour, contrary to what currently appears to be the Fed's preference, tapering MBS purchases quicker than treasury purchases.

Instead, let me venture an altogether more outrageous "suggestion" even if I am not sure this would work at all. 

Another proposition is then simply that the Fed is buying the wrong thing. Quantitative easing can principally be targeted at all kinds of assets and with the Fed effectively hoovering up the entire MBS market, maybe it is time to look farther afield. One opportunity would be to realise that consumers' demand for homes is not only a function of low long term rates. Betting on a steady increase in homeownership and thus positive response from households to the ability to lever up their balance sheet may not work post 2008. 

Specifically, we should note the decision by Blackrock to start marketing bonds backed by the rental income of the thousands of properties the investment company has spent the past 4 years accumulating

Quote FT; 

Now they are beginning to package the rental proceeds from those homes into the kind of “sliced and diced” securitisations that proliferated before the bursting of the housing bubble in late 2007. This week Blackstone sold the first of these bonds – a $479m deal that bundled the cash flows from more than 3,000 single-family rental properties scattered across Arizona, California and Florida. 

Quote Bloomberg; 

The market for rental-home securities may grow as large as $900 billion, assuming 15 percent of annual home purchases are conducted by investors and 35 percent of those and existing rental-home owners turn to the market for financing, according to Keefe Bruyette & Woods Inc. Banks have been the main source of financing for new property landlords such as Colony Capital LLC and Blackstone, which has spent $7.5 billion on about 40,000 houses.

Of course, at $900 billion (even with positive expectations on the market size), this market is obviously currently too small for the Fed to step in, but it also means that the Fed could support this obvious channel of the US housing market revival by deploying much less financial firepower. Alternatively, the Fed could start buying straight corporate bonds of which there are now more outstanding than MBS in the US.

Now, if you can sense the irony here at the end of the post then you wouldn't be entirely mistaken, but we should understand that it is perfectly within an aggressive Fed's mandate to seek out new avenues to transmit their policies to the real economy. 

Central banks are becoming increasingly certain and secure in the position that their activist policies are not only effective, but also that they can orchestrate orderly exits. I am personally highly skeptical that this is the case.  

Regardless of whether you agree with this or not, we should understand that the notion of an increasingly activist Fed supports the idea of tweaking not only the size but also composition of its asset purchases. Just like Alice, Yellen could be about to take one step further into the rabbit hole with painful consequences for investors further down the line. 

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