I have a lot to say about the utterly insane world we know live in where the worse the news, the stronger the rally, but too little time to say it in at the moment. Stay tuned!
]]>Still, two points have caught my attention in recent weeks. The first is the decisive push against austerity with the IMF, EU commission and Germany all seemingly content to allow the periphery more time. The second is the combination of two extraordinary headlines on Bloomberg in the past couple of weeks.
The first article refers to comments by GS’ CEO Lloyd C. Blankfein that he is getting a little worried about a back-up in interest rates. Specifically, he invoked 1994 as a comparison which, I am sure, gave many food for thought. Coupled with a research note from GS noting a “zero percent upside” for Spoos into year-end many investors and analysts were asking themselves whether the Illuminati knew something was coming.
Of course, before we put on our tin-foil hats, we should consider that the comments by Blankie were simply poor form. How dare he! In a world where investors are buying Australian banks as safe “dividend yield” havens, where Wal-Mart, Apple etc are financing themselves below the rate of inflation and where defensive stocks are going parabolic due to their assumed safe income stream, invoking 1994 is just unfair.
Fear not however; contrary to 1994 and the beginning of the Greenspan era, investors have complete faith in Bernanke.
Bond investors are gaining confidence that Federal Reserve Chairman Ben S. Bernanke will unwind the central bank’s unprecedented $3.3 trillion balance sheet without sparking a crash similar to 1994, when Alan Greenspan surprised the market by doubling benchmark lending rates in 12 months.
Mis-communications, policy error and lack of transparency were all ailments of the old Fed, but not the new. Now, I am not out to get central bankers here but I think it is important to understand why investors are so happy to trust Bernanke. More specifically … so far, they have made and are still making a lot of money on the back of Bernanke et al’s ZIRP induced global hunt for yield. I find it hard to believe that bond investors (and indeed any investor) would even contemplate that Bernanke suddenly turning off the faucet of free money. I mean, that after all would mean bankruptcy for them.
However, with equities continuing to defy a lacklustre economy and headlines about retail investors betting it all on Tesla next week’s FOMC minutes may cast some light on how worried the Fed is, if at all, about the dash for yield and other un-intended consequences of ZIRP and QE.
So, starting where I began with another Bloomberg headline extolling the rising confidence of the average American we should be positive that things are improving. However, the real test for asset prices and the economy comes with monetary policy normalisation. And despite what your mate with the Tesla stocks might tell you, I think investors are more than a little worried about the Fed taking its foot off the gas; and with good reason.
]]>Calling a top in the global dash for yield has so far been futile. Indeed, with ZIRP now a structural characteristic of the global financial system, one has to countenance the fact that the race to the bottom in global yields have only just begun. Consider for example the latest uptake for Wal-Marts bumper refinancing issuance schedule in 2013. Recent results on the earnings side and forward guidance have been less than impressive, but investors have still provided a healthy bid for the 2016 issuance. More spectacularly however, is this from Bloomberg;
The company’s weighted average coupon of 2.09 percent on yesterday’s transaction is about half the 4.02 percent paid on its $3.69 billion of dollar-denominated debt maturing this year, Bloomberg data show.
I have no specific agenda on Wal-Mart here (no positions etc) and I have no real insight into whether Wal-Mart will do well or not so well in the coming 12 months, let alone looking as far ahead as 2016.
Crucially however, I don't need to in order to point to the conundrum of the numbers above.
Let me try to analyse this then from the point of view of the macroeconomist whose luxury it is to look at the big picture. We don't need fancy charts, regressions or other advanced statistical methods. We only need two numbers. Inflation in the US is currently running at about 2% YoY and 5y to to 10y inflation expectations measured by the University of Michigan recently printed 3.3%. These two numbers are difficult to reconcile with the average coupon payed by Wal-Mart.
Buyers of Wal Marts bonds at current prices are consequently, based on current inflation readings and long term inflation expectations locking in a negative real return. This would be odd, but not unheard of in the context of sovereign bonds. Sovereigns have a printing press and especially in the context of elevated systemic financial risks, even negative nominal yields may make sense (mainly on the short end of the curve of course). In such situations, investors and in particular financial institutions merely seek certainty that the principal will be paid back and may even pay for the "privilege" to see such principal being paid out in freshly printed central bank reserves.
But Wal-Mart is not a sovereign and does not, as far as your humble scribe is aware, have a printing press tucked away in their Bentonville basement. Indeed, Wal-Mart is a highly complex business with inherent risks and uncertainties. But it seems that the market is willing to dispense completely with this risk at the present moment.
Of course, the story is not that simple and not even the macroeconomist can neglect microeconomic structures. Wal-Mart is a behemoth and any large fixed income manager need to hold its bonds to some degree, if only to not veer to much away from her benchmark. In addition, Wal-Mart still holds a coveted AA rating which is of course good for capital requirements in testing times such as these. Finally, Wal-Mart's free cash flow is too good of a prize not to have a crack at and buying its bonds is of course, to some extent, a claim on this (well technically it isn't of course, but you get my drift I am sure). All in all, the Wal-Marts of the world will always be able to find buyers of their debt, but this is not strictly the issue I am adressing here.
As such, beyond all the reasons for why the Wal-Mart transaction makes perfectly sense in a well oiled big economy such as that of the US, the basic math looks a bit ridiculous in my view. Even if the supply of capital for Wal-Mart debt issuances is structurally deep and thus lends itself to the description of a very liquid market, we must pause to reflect the inelasticity of such capital relative to the price. Would there also be readily available capital for Wal-Mart refinancing at 1% or even at 0% or perhaps at -1%?
The answer is of course that such current fixed income "mispricing" is condoned and encouraged by monetary policy through the promise to keep benchmark rates at zero. Yet, this is hardly a very useful answer in the context of Wal-Mart and similar corporate issuances. Global and US fixed income managers are highly intelligent people with access to endless streams of historical and current information that would allow them to put a price on the business risk of Wal-Mart. Yet, such risk has been completely discounted in this case and the only thing we can say is that the dash for (negative) yield continues. I find this perplexing and it is a worrying sign for the global economy and her investors in my view. Higher rates as imminently unlikely as they currently seem would not go down well in the current investment climate.
]]>As always, Moody's are coming in after the fact. It has been pretty obvious for a while that to term the UK as a safe haven only made sense if you believed that continental Europe would sink into ground leaving an open sea between Dover and the Ural. This was always going to be one of the more unlikely outcomes, but with the famous speech by Draghi that the ECB would do whatever it takes to preserve the euro, the wheels were slowly set in motion for a re-rating of all safe haven trades (and thus the EURGBP going vertical and the GBPUSD plunging out of its recent 3y range).
The main question we are left with is what a safe haven actually is? Should we look at traditional macro fundamentals which would certainly, from a capital flows perspective, seem to offer a usable framework or is a safe haven simply what the market terms it to be?
This is an important question to think about when considering global capital flows and carry trade fundamentals. Take Japan for example. It used to be considered a safe haven only 6-12 months ago. A high external surplus, deflation (generating positive real returns), and low volatility in the bond market were all factors. However, recently two things have happened. The first gives me hope that macroeconomics has not completely lost its usefulness. The fundamentals of Japan have simply changed for the worse. Growth has slumped, the external surplus has disappeared and the budget deficit has ballooned. Still, the second major change is that Japan through both its monetary and fiscal policy initiatives in the past 12 months has simply sent a signal that it does not wish to be a safe haven anymore.
Indeed, Japanese politicians (and its corporates) would probably prefer that we went back to the days of the Yen carry trade.
Cue of course the re-emergence of currency wars as a major talking point. However, the fascinating point about this report by Bloomberg (and similar reports) is that e.g. Australia and New Zealand are lumped together with Norway and Switzerland as "victims" of carry trade flows as a result of a race to the bottom among G4 central banks.
This is fascinating because only someone deliberately ignoring even the simplest macroeconomic analysis would group these economies together. If you don't believe I recommend a two step process; read up on simple open economy dynamics and then compare the twin deficits (budget balance + current account balance) of Australia, New Zealand, Norway and Switzerland. See the difference?
The only reasonable explanation is of course that everything has been reduced to a hunt for positive yield. This makes sense in a world where ZIRP in all the major central banks force investors into any and every instrument that offers a positive nominal yield (never mind that the real yield which will probably be negative). I think this process is easy to rationalise, but to frame these flows in relation to safe havens makes absolutely no sense.
What now appears to be UK's fall from grace is a pertinent reminder and this leads me to the view the notion of a safe haven is probably one of the most mis-used concepts in the economics media today. Keynesians v Austrians would be another one (but that is for another day!).
So what is a safe haven you might ask? Well I certainly don't have the final answer, but I would suppose it should as many as the following characteristics as possible.
1) Large, stable and structural external surpluses
2) High net savings, strong net foreign asset position
3) Positive government balances, stable and low domestic interest rate environment
4) Non-volatile real return on base rate linked products
5) Open capital account (ease of getting money in and out, but because of the strong current account currency volatility would likely be relatively low)
6) Deep and liquid financial markets.
I am sure I have forgotten something, but it obviously occurs to me that such and economy does not exist today. It is better then to recognize this than trying to lump all kinds of different economies together as safe havens just because they offer positive nominal yield; because eventually even the most solid perceived safe haven may ultimately fall. Just look at the UK.
]]>As such, I thought that I would return to a topic that I actually do know a little about and this interesting piece in the WSJ by Carl Bialik on US fertility and the idea of a crisis driven birth collapse in the US.
A recent report said the U.S. birth rate has dipped to a record low level. But another measure of the nation's fertility remains comfortably above its historic low. The mismatch shows that even in a country with comprehensive birth statistics, summarizing population trends is far from straightforward.
The article makes no judgement either way and essentially keeps to lining up the arguments without making a statement about which measures are most correct. The main debate is driven by reports that the US birth rate has plummeted since the financial crisis and that this negative shock could have a lasting impact on US population dynamics.
However, as the article suggests, measuring fertility is not straightforward and indeed while the article builds its discussion around the notion of total births per 1000 women (crude birth rate) and the total fertility rate (average children born to women in their childrearing age), no mention is given of total cohort fertility which is the completed fertility per cohort. Arguably, this last measure is the most important one, but also the most difficult one to observe since we can only see this after the fact (although we can make qualified guesses of where this is headed for a given cohort based on the interaction between tempo and quantum effects of fertility).
So, what is the story in the US? Well, the crude birth rate recently hit all time lows, but the total fertility rate remains stable and close to replacement levels and this latter point is, in my view, giving too little credence in relation to the most recent concerns raised on US fertility.
However, there is no doubt that the financial crisis appears to have had a noticeable impact on US fertility patterns. In theory, an economic recession should not have a lasting impact on completed fertility. This is mainly because a normal economic recession does not have a lasting impact of families' life course trajectory and decisions to have children. It may lead to an increase in postponement, but that effect should be reversed once the recession ends.
The key question is whether this particular economic crisis is different and whether we can expect a lasting impact on fertility in the US (and perhaps elsewhere)?
I would venture a hesitant no here, but the jury is still out, and there is no doubt that the specific nature of the recent economic crisis as one of being associated with a structural level of too much debt is a worry. A prolonged period of deleveraging which now appears to have begun the US and elsewhere in the OECD could lead to a permanent and irreversible postponement of fertility decisions in the US, but so far the fact that US fertility remains close to replacement levels (and never dipped below) is a definite positive that has, so far, received too little attention I think.
Grantham Lays Down the Gauntlet on US Growth and Demographics
If Carl Bilak's article does little to come up with an argument for or against the notion of the sturdiness of US demographic fundamentals a recent piece from GMO by Grantham is much more vocal in its worry that the US economy may be headed for zero growth and that demographics are to blame.
First of all, Grantham is fundamentally pointing to falling trend growth in the US. This is the case not only in the US but across the OECD. Indeed, trend growth if measured with a very broad stroke is probably falling in all major global economies, developed as well as so called emerging economies. The reasons for this are pretty simple. All the things we use to calculate or account for growth are slowing down; demographics, capital formation and technology/productivity although this last bit is surrounded by a huge uncertainty and could surge or slump. Most economists would see productivity as a part of the process (i.e. it is endogenous) and thus something we can affect, but technological progress does tend to have an unpredictable and disruptive cycle which is difficult to account for.
Still, to take such a broad sweep at growth and apply equally across global economies is too general a narrative to hold up to closer scrutiny.
Enter US population dynamics and its coming “growth” effect.
On US demographics, I think Grantham focuses on long term trends of working age population growth which are obviously down in the US. However, they are down for all countries and over such a long time frame that it becomes meaningless to discuss them without some aspect of relativity. Retiring baby boomers are a drag on US growth and the lack of rising female labour force participation (because it has already happened) is also a minus, but this is also pushing the narrative a little bit.
Surely, a boost in growth from increasing female labour force participation can only happen once and is not strictly a "drag" on growth when it ends. Crucially however, Grantham interprets exhibit 1 depicting growth in the US working age population in a "glass half empty" kind of way. We are told to focus on the declining trend, but I would note the remarkable fact that the US working age population is set to enjoy positive growth beyond 2030. That is a major relative tailwind compared to the rest of the developed world and indeed emerging markets. All countries in the world have a large challenge in the context of the compatibility between ageing and a market economy with pension schemes and health care systems, but the US seems in a relatively good position to cope with this from the point of view of demographics.
Going back to the discussion on fertility, I am surprised that Grantham does not focus a bit more on the fact that it never slumped massively below replacement level in the US which augurs for strong tailwinds to household formation. If you combine this with intra-US labour mobility you get a strong foundation for growth I think. Or at least, you get a more nuanced view of the US compared to for example many other OECD economies (Japan and Europe) where demographics are much more decisively manifesting themselves in the form of headwinds.
Two charts from the GMO piece that should make us worry a bit though are ex 2 and 3. Working less hours and falling labour force participation (and it is falling not only for women) are poison for growth because it reduces the potential growth rate per unit rate of inflation. Popular speaking, it reduces the natural level of output before the output gap turns positive (and you get excess inflation and no real growth). This is a huge challenge in the US and the persistently falling labour force participation rate in the US in a post crisis is a worrying development which needs some sort of structural/reform response as it is completely unrealistic to expect the Fed’s quanto easing policies to lead to a structurally better labour market.
In the end, I would say that it is difficult to disagree with the overall narrative set out by Grantham because it really sticks to the straight and narrow and basically says what we already know, name that trend growth will fall.
Critically however, Grantham notes the concept of "zero growth" and thus refers to the idea that trend growth in the US may fall to zero. I don't see that and this is an important qualifier.
I think there are a lot of economies in the OECD where "trend growth" as defined by conventional economic models and theories may be zero (Japan, Italy, Spain and some parts of Eastern Europe). But I would not put the US in that group and demographics represent one of the main reasons for this. There may be many reasons why the US economy may slump to zero growth in the future, but demographics aren’t one of them.
I have a lot to say about the utterly insane world we know live in where the worse the news, the stronger the rally, but too little time to say it in at the moment. Stay tuned!
]]>As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.
Great emphasis has been attached to the chairman's use of the word "grave" as a clear tell-tell sign of more easing to come. I find this quite interesting since it is one of the first instances of such "new speak" interpretation of the Fed's statements akin to the good old days of Trichet and the utterance of (strong) vigilance. Needless to say, next week's jobs market report has suddenly been propelled to a key market event and every single US data point will now be watched with caution. On that note, the next ISM reading as well as consumption figures will be equally important to watch.
I think Tim Duy’s interpretation is the right one then (hat tip Calculated Risk) with my emphasis.
On net, Bernanke's speech leads me to believe the odds of additional easing at the next FOMC meeting are somewhat higher (and above 50%) than I had previously believed. His defense of nontraditional action to date and focus on unemployment points in that direction. This is the bandwagon the financial press will jump on. Still, the backward looking nature of the speech and the obvious concern that the Fed has limited ability to offset the factors currently holding back more rapid improvement in labor markets, however, leave me wary that Bernanke remains hesitant to take additional action at this juncture. This suggests to me that additional easing is not a no-brainer, but perhaps that is just my internal bias talking.
On balance the main point for me is that the recent change in economic data clearly merits policy change on the basis of the Fed's reaction function.
The unemployment rate in the US is sticky and the Fed has been persistently concerned about this which is indeed a strong signal to the policy bias especially as inflation expectations are well behaved. Inflation has come down significantly in the US running at 1.4% YoY and the Taylor Rule rate is now declining (though still in level terms way above 0 but that has more to do with the inputs than anything else). We have had two consecutive months of sub-50 ISM readings and consumption growth appears to be rolling over. My interpretation of the forward looking indicators is that they look better than the consensus suggests, but the Fed lives in the here and now and will act accordingly.
Another interesting point here is that despite the visible and strong recovery in the growth rates of US housing market indicators, Bernanke mentions the level of the housing market and not the change which suggest that the despite a good run of data with respect to the change in housing market indicators the level is still seen as depressed.
The bottom line is that some form of easing is coming but what I find highly uncertain is the timing and aggressiveness of such easing. The August minutes had already stipulated potential moves for the Fed in the form of an extension of the low interest rate commitment, lowering interest rates on excess reserves as well as an extension of Operation Twist or outright asset purchases (probably through MBS securities). But which of these measures will be employed and in what order?
One thing for example which I find very interesting is the glaring gap between Bernanke's discussion of the effectiveness of unconventional monetary policy and its effect on the real economy (i.e. labour market). In that sense, it seems quite clear to me that quantitative easing can have a strong effect in the context of imminent deflation risks and strong downward pressures in asset prices. In such an environment the portfolio effect and, indeed, outright price effect from aggressive central bank action can be very effective.
However, whether quantitative easing can be effective in countering a structural and sticky unemployment rate (and indeed a structurally declining labour force participation rate) seems much more uncertain to me. Obviously, this goes back to the point that the Fed is the wrong tool for the job at hand, but it also raises the issue of what kind of easing the Fed is planning here.
Of the measures mentioned above one of the only things which would have an effect on the labour market (from a theoretical point of view) is an extension of the low interest rate commitment. This would be a signal to companies that their cost of capital would remain low and incentivise investment and thus, in theory, additional labour input. But such a process is slow and arguably a weak remedy in the context of structural labour market issues.
More generally, we must ask ourselves whether an extension of the low interest rate commitment be enough for the market Clearly not and in any case, an extension much beyond Bernanke’s term would be meaningless as the looming presidential election has created uncertainty as to how strong this commitment is, if for example Bernanke is faced with a Republican president.
What about an extension of Operation Twist then? If this is combined with an expansion of the balance sheet through purchases of MBS I think this could be an effective medicine (although in general I find it hard to see how it could meaningfully affect the labour market). However, the theoretical argument here is fair. By influencing long rates the Fed is likely to stand the greatest chance of supporting the ongoing recovery in the housing market and thus, by derivative, the US economy.
Ultimately, I see two sources of uncertainty here. Firstly, it is not clear to me that the US economy is heading into a hole in the second half of 2012 to an extent that would allow very strong Fed action. Secondly, while the Fed clearly seems committed and perhaps even pre-committed to more easing the nature of such easing and its scope is still very uncertain to me. The upside risk attached to much stronger easing is clearly there (not least because we also have the ECB coming in with policy measures soon), but the spectre of grave disappointment has not been completely extinguished in my view.
]]>In principle I agree with Steen Jakobsen's latest views that the upside is strongly driven by the global QE put and low holiday volumes. Hope of policy intervention as the market grinds up and beyond new highs usually is bad sign. Still, as a macro guy I should also point out following for example the latest from Simon Ward that the macro data has indeed improved. For one, investors should note that emerging economies have been slowing down to a grinding halt for 12 months and are likely already turning up from a bottom. In the US, the continuing revival in residential and commercial construction is real and starting from a low point which suggests that more upside surprises are possible here.
The problem though is that the amount of conflicting information right now is dizzying and against a backdrop of a continuing fear of the end of the workd, this creates and even more binary and frustrating world for investors. Hussman for example believes we are on the verge on a major inflection point.
We are presently in an environment that has historically been associated with the overvalued segment of late-stage bull markets. This segment of the market cycle has been frustrating for us before, and that frustration may not be over. Yet in each instance, our defensiveness was overwhelmingly vindicated. The drum-beat of investors is that “this time is different.” Simply put, I doubt that this time is different.
With that in mind, my base case remains that the scope for a choppy upward movement of the equity market is not yet exhausted and, consquently, that complacency and euphoria can get much more extreme.
The Bad Bank is Dead, Long Live the Bad Bank
Investors have only slowly been given information on the Spanish bailout which was (in)formally announced back in the beginning of July with €100 billion for the banks. By the letter of the law, Spain has not yet requested for aid and despite the ECB's verbal intervention outright ECB financing of Spanish deficit spending will require full Troika programmes.
So far then, it is difficult to know whether to laugh or cry at the news that Economy Minister Luis de Guindos and the government has apparently decided to create a new bank just months after the other bad bank (Bankia) went belly up.
Quote Bloomberg
Spain will put its bank rescue fund in charge of the bad assets separated out from the nation’s struggling lenders that are receiving a European bailout. The FROB fund will be the main shareholder in a so-called bad bank, according to a proposal that will be approved by the Cabinet on Aug. 24, Economy Minister Luis de Guindos told the Efe news agency in an interview today.All the banks receiving loans from European rescue funds will have to transfer their non-performing assets to the bad bank, he said. The comments were confirmed by a Spanish official, who asked not be identified, citing government policy.
You seriously cannot make this up, but the only difference now is that it will be easier to add the liabilities to the Spanish sovereign since, sooner or later, the FROB itself will have to be bailed out. Of course, Spain may ask for an official bailout long before that and then the transformation will be complete. Losses in the Spanish construction and RMBS industry will have migrated from one consolidated bad bank balance sheet to another, on to the sovereign and finally into the heart of the Eurosystem.
This process has been clear for a long time what hasn't has been the speed and twists and turns for us to get there. Speaking of twists and turns, the news coming out of Germany (apart from a rapidly slowing economy) is also mixed with Merkel apparently fighting other members of the government on whether to cut Greece some slack all the while that Der Spiegel apparently is reporting that the ECB is going to cap yields in the periphery.
Until action proves otherwise, the base case remains that the ECB will refrain from strong intervention until memorandums of understandings have been signed, but Spain and Italy are big fish compared to Greece. Their respective governments know that they could bring the euro down and inflict mortal damage to Germany. It is difficult to see exactly what the position of Germany is here, but one is certain , Germany (and all other so-called safe havens) have benefitted from the ongoing euro crisis charade in that it has been significantly cheaper for them to borrow. Italy and Spain could merely be seen as asking Germany to pay for this privilege.
Ultimately though the market will call Italy and Spain on their bluff and the onus will be on the ECB to do just enough to keep the boat afloat, but not so much as to be seen caving in to guerilla tactics. This is already an incredibly difficult minefield for the ECB to maneouevre and it won't get easier as the recession intensifies. The end result is that losses will increasingly be mutualised and this may, in the end, make it more palpatable for the ECB to engage in outright monitisation.
]]>Still, Draghi seemed to pull yet another rabbit out of its hat by explicit reiterating the irreversibility of the euro and also explicitly mentioning that there would be no going back to the Lira or the Drachma. Empty words to buy time you might say. Not quite and while the ECB may certainly now buy as many peripheral bonds as it wishes if it deems convertibility risk to be a real issue money is already trickling into cash strapped peripheral economies through the arcane tool of emergency liquidity assistance (ELA) by which the national central banks can support specific banks deemed to be illiquid. The most important news coming out last consequently came late Friday night when Reuters reported that,
The ECB's Governing Council agreed at its meeting on Thursday to increase the upper limit for the amount of Greek short-term loans the Bank of Greece can accept in exchange for emergency loans, the newspaper said in an advance copy of the article due to appear in its Saturday edition.
Until now the Bank of Greece could only accept T-Bills up to a limit of 3 billion euros ($3.70 billion) as collateral for emergency liquidity assistance (ELA) but it has applied to have this limit increased to 7 billion euros, the daily said, citing central bank sources.
The ECB Governing Council gave this wish the green light, the paper said.
The move should enable the Greek government to access up to an extra 4 billion euros of funds, the paper said, adding that this should ensure the country keeps its head above water until the "troika" of the European Union, the European Central Bank and the International Monetary Fund decide on the disbursement of the next tranche of money from its aid program in September.
I would recommend anyone to read this note by Morgan Stanley from 2010 as well as this more recent research note by Citi's Chief Economist Buiter. Both provide a good re-cap of what the ELA is, why it is where and how it is used. The main definition from the Eurosystem's own documents is useful however;
One of the specific tools available to central banks in a crisis situation is the provision of emergency liquidity assistance (ELA) toindividual banks. Generally, this tool consists of the support given by central banks in exceptional circumstances and on a case-bycase basis to temporarily illiquid institutions and markets. This support may be warranted to ease an institution’s liquidity strains, aswell as to prevent any potential systemic effects, or specific implications such as disruption of the smooth functioning of payment andsettlement systems. A credit institution cannot, however, assume automatic access to central bank liquidity.
The provision and magnitude of the quantity of ELA in operation at any given point in time is not aggregated by the ECB or the Eurosystem, but will instead be reported by the national central banks. This is logical as it is explicitly stated that national central banks take on the market risk. Yet, the question market participants are now obviously asking themselves is what this means in the case of an irreversible euro. The following quote from the 1999 ECB annual report is crucial.
The main guiding principle [for the ELA] is that the competent NCB takes the decision concerning the provision of ELA to an institution operating inits jurisdiction. This would take place under the responsibility and at the potential cost of the NCB in question.
The ELA as it is described here is then an operational tool the national central bank can use in a situation where a specific financial institution is in trouble. Examples of such usage of the ELA was the €42 billion guarantee granted by the German government to Hypo Real Estate in 2008 through a special purpose vehicle (SPV) who itself tapped the Bundesbank for liquidity through the ELA and which then got collateral from Hypo. In 2009, the Belgian bank Fortis was also given access to the ELA on the eve of its collapse with loans, according to Barclays, amounting to about €54 billion.
These two cases are examples of the intended use of the ELA facility in so far as goes the fact that both Germany's and Belgium's current ELA balances are 0 (as far as we know from current data).
Using the ELA as a bailout fund
The ELA has been active at several occasions during the crisis, but the usage of the facility in Ireland and Greece represents a completely different use of the facility than the one originally intended. According to figures compiled by Citigroup Ireland has had a constant use of the facility since 2008 with the central bank in Ireland providing anything between €40 and €60 billion since 2010. Most recently, Greece has also taken to the ELA to the tune of about €55 billion [1].
Such constant use of the facility was never envisioned and suggests that the ELA is being used as additional bailout funding in countries where negotiations with the IMF/EU bailout party has hit a snag. This is evident in Greece where the ECB effectively pushed the country into ELA funding earlier last month as Greek government bonds were deemed unacceptable as collateral until the Troika had completed its review.
Thus, The wording of the Reuters article above thus suggests a wholly different use of the ELA, namely as a very last resort used simply to keep the lights on in a country in tight negotiations with its bailout counterparties. Of course the price of such funding is higher, but this is a technical point here which is irrelevant for a country on the edge. It is not difficult to see how precarious this could be for the ECB which could effectively be forced into kicking a country out of a the euro by shutting off ELA funding. More specifically, this would happen by the ECB effectively instructing its counterparties that whatever reserves created by the national central bank in question. But even more precarious could be the process by which the ECB first deems an individual country's bonds ineligible as collateral only to have to accept that the national central bank takes such bonds in collateral for ELA funding.
With this backdrop in Greece, and with a Spanish request for ELA funding coming sooner rather than later Draghi's comments on the irreversibility of the euro are critical. Market participants can consequently now countenance that the ECB will not shut a country out of the ELA and national central banks in Greece and Spain will take note of this. More than a promise to intervene in the secondary bond market through the SMP, the implicit commitment to keep the ELA open could be the real bazooka.
However, it is also clear that the ECB and the EU could end up in a royal mess. Usage of the ELA is essentially, from the point of the ECB, a pull mechanism by which national central banks request funding. This is in line with the operational use of the LTROs in which euro area banks applied for as much funding as they needed and put up collateral to back it. This was not, strictu sensu, a breach of the famous article 101 in the EU treaty prohibiting but it came close in the context of French president Nicolas Sarkozy recommending banks to buy sovereign bonds. The consistent lowering of collateral requirements as well as stories about reverse repos with banks' own securities also added weight to the idea that the LTRO was merely an alternative way to bring sovereign bond yields down.
The ELA then opens up to a much more problematic avenue in which the ECB could end up shouldering the counterparty risk of the invididual national central banks. Going back to the point emphasized by the Buiter and Citigroup it is suggested that the steady use of the ELA at the behest of the national central banks over time may undermine the monetary union itself akin to the developments which ultimately tore apart the Rouble zone (my emphasis).
We think the existence of ELA on a country-by-country basis undermines the monetary union by allowing different monetary, credit and liquidity policies in different member states of the Eurozone. The damage is not (yet) fatal because the GC of the ECB sets the upper limit on the size of the credit an ELA facility can extend and because the GC also has a veto over the terms on which this credit is extended. As noted, the ‘protection’ offered to the Eurosystem by the denial of loss sharing for ELA exposure is only effective if the central bank and sovereign backing the ELA exposure have sufficient loss-absorption capacity.
Clearly, neither the sovereign in Ireland, Greece nor Spain are in any position to shoulder losses in their respective banking system and indeed, the usage of the ELA in countries have opened up avenues liability and loss migration to the very heart of the Eurosystem. With Draghi now putting his weight behind the euro the ECB may find it even more difficult to effectively shut a country out of the usage of the ELA and with Spain about to wind up its own ELA, the ECB may have cornered itself.
While the ELA may always be effectively in-operational due to the lack of collateral we have already seen the ECB backpedaling on several occasions and quite simply, in an emergency a national central bank will accept whatever collateral the domestic banking system can come up with. The ECB is effectively already doing so and it is unreasonable to expect anything less in Greece, Ireland, Spain or any other individual country.
Summary
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[1] - These figures are from Buiter's piece and are best estimates. It is very difficult to get a handle of the real magnitude since the national central banks are, understandably weary about giving out too much information, and since the ECB does not record these transactions on its balance sheet.
]]>Following up on FT Alphaville's coverage, one question that is intereting to consider is the following.
2) The movement of M1 and M2 in recent years seems not to have told us anything helpful about inflationary prospects. Should the Fed finally ditch them and start concentrating on another measure, perhaps one that incorporates some of the items above? Or bring back M3 (which at least included such shadow banking elements as institutional money market funds and repo)?
Initially, I should point out that I disagree with the premise of this statement. I think that there are still important effects from fluctuations in M1 and M2. Specifically, I believe that while being in structural process of deleveraging may certainly mitigate the inflationary pressures from central banks generating excess reserves (and liquidity) in the system, it is dangerous to assume that expanding base money does not have a real economic effect.
Still, this raises a very important point. The traditional monetary policy transmission mechanism is broken and as a result the size and expansion of base money aggregates have little bearing on credit creation in the real economy. The key question is the whether central banks should extend their control of the money supply further down the credit foodchain (i.e. closer to the end user/beneficiary of the credit)? And if you answer to this is yes, how do central banks do this most effectively.
Firstly, it is important to emphasize that, in many ways, they already have. Initial responses to the crisis in the US (and QE conducted by the BOJ) have been engaged in strategic and direct purchases of several kinds of marketable debt and equity securities, but central banks generally do not like to do that. Historically, the Bank of Japan has been most direct trying to influence market prices through the purchase of corporate bonds and exchange traded funds.
Now however, they are at it again of course. The BOE recently suggested open market operations with strings attached in the form of banks only getting access if they added to their balance sheet and in Europe, the ECB has cut its deposit rate to 0% and may even push it into negative this week.
The problem however is that it is very complicated for the central bank to do this effectively and a central bank will always be adverse to taking direct market risk (even if e.g. the allegedly most conservative central banks of them all, the ECB, has taken substantial market risks through the collateralised LTROs). In addition, targeting M3, M4 etc would mean an even more direct involvement in the credit process by which the central bank potentially acted as direct underwriter for pools of securitised loans of all shapes and sizes. This adds illiquidity to the balance sheet and exposes the central bank to significant mark to market risks which eventually may have to be covered by printing money. Such an implicit backstop to securities that the central bank may agree to buy creates significant moral hazard.
But it is certainly a fair question to ask whether central banks have been using the wrong tools as e.g. Izabella suggests in her coverage of the concept of the negative money multiplier.
Traditionally, a central bank will respond to a liquidity trap by supplying (potentially) unlimited levels of excess reserves to the banking system and thereby expanding the potential credit supply in the economy. The counterbalancing asset side entry here will usually be short term government bonds but also, if need be, longer term government securities. In this sense, expanding the balance sheet at the zero bound is essentially a fiscal expansion. However, as Izabella suggests, this may actually be counterproductive in an economy suffering from a structural lack of liquid and investment grade collateral.
The central bank will then actually exacerbate the lack of such assets by doing textbook QE which involves creating bank reserves in exchange for short term government securities. Demand for government securities (collateral), the story goes, would be more than enough to keep yields down and allow the government to conduct fiscal expansion at the zero bound. Still though, one would have to assume a complete lack of any market response from bond vigilantes ad infinity for this to work. I am not sure that I accept this.
So where does a broader monetary aggregate target come in? Well, from the account above the central bank could do two things.
1. Act on the liability side by aggressively cutting excess reserve requirement and enforcing a penalising rate on excess reserves. This would be a direct way (through the liability side) to attempt to jump start the money multiplier and force up velocity, but it will require the central bank to be indifferent between currency and reserves on its liability side (see below).
2. Avoid crowding out demand for safe collateral by booking anything but government securities on the asset side.
On the second point, I would note that this assumes a complete lack of bond vigilantes of any kind and thus no disciplinary market action in the context of financial repression. In the context of structurally overlevered governments across the developed world, I am not sure that this is a reasonable assumption over time. What would Gilts be trading at if the BOE was not holding 30% of the total stock outstanding and how would this have affected the government's ability to borrow. In addition, taking direct market risk by e.g. purchasing pre-assigned tranches of securitised loans (to beef up broader monetary aggregates) would certainly not work if the underlying problem was one of a structural lack of solvent credit demand. I have argued for example that this is a major part of the problem both in the context of private and public borrowers.
On the first point, events have caught up with theorizing here with the ECB the first major central bank now imposing zero interest rates on its deposit rate (the Riksbank did this in 2008/09 too) and there is a serious probability that the rate may be moved into negative.
I have been lucky to have the opportunity to discuss this with the financial columnist and investor Sean Corrigan who makes the following crucial point.
People are treating this [negative deposit rates] in a completely erroneous fashion. Even negative rates cannot force the banks to lend out the deposits they hold at the central bank; this is to assume they - as a whole - have choice in the matter: they do not. If the central bank creates what is called 'outside' money, by buying securities, etc, the corresponding reserves cannot be voluntarily removed: they have to be held as CB liabs/commercial bank assets on the central bank balance sheet.
(...)
What such a move could possibly do is to make it more imperative for banks to leverage up by creating new, extra loans (To whom? On what terms?) and to accept new customer depo's (given that they hold a huge surfeit of reserves on their balance sheets with which to backstop these) and so compensate for the negative rate drain by the volume effect. I take this as dubious, however, given normal credit concerns and, in some cases, binding capital constraints.
Sean then goes on to make the final point that if the central imposes negative interest rate on reserves while at the same time wanting to maintain the size of its balance sheet, it would have to generate currency as reserves were withdrawn.
I think a couple of points are important to note at the offset.
The situation at the ECB and the Fed/BOE is different. More specifically, reserves created in the Fed/BOE is, as Sean points out, "outside money" and is thus what we could call "push QE". The central bank has a policy objective to affect government bond yields and the only way it can do this is to generate reserves in the system. At the ECB and while the central bank may certainly have intended to affect government bond yields in the periphery this was "pull QE"; i.e. reserves were pulled from the ECB based on banks' demand for such liquidity and, presumably, their need to shed themselves for collateral.
One of the main objectives as stated by the ECB was to provide liquidity to banks who could not otherwise refinance themselves in the short term money market. I think it is critical here to note that while the Fed and the BOE have always put forward specific targets for their QE operations, the ECB has not! If the banks had put up 2 trillion worth of collateral in the LTRO and asked for 2 trillion in liquidity they would have gotten it!
Anyway, to the point that banks are forced to hold these reserves (as a counterpart to the size of the balance sheet), in the perfect world it is not certain that this is the case. Let us assume a central bank conducts QE through the expansion of reserves with two objectives in mind.
1) To affect government bond yields (perhaps to allow the sovereign to run higher cyclical deficits for a period to boost aggregate demand).
2) To improve risk sentiment and risk taking in the economy through higher credit creation by commercial banks.
One immediate effect of such a policy in an environment where the monetary policy transmission is broken is that while government bond yields may go to zero it has no effect on lending to the real economy.
What can the central bank do? Not a whole lot as it were.
The central bank created the reserves in the first place and cannot easily induce banks to lend these out without compromising its asset side. In other words, it is difficult to pursue both objectives directly at the same time.
Specifically, if banks started to draw on its excess reserves to lend out to the real economy the central bank would need to one of two things. Maintain the size of its balance sheet constant by creating currency or reducing its holdings of securities on the asset side (government bonds). The latter is difficult to do especially if the central bank has been very aggressive in its sovereing bond purchases. Still, theoretically the central bank will be informed by the notion that the economic multiplier of commercial banks lending out to the real economy is higher than central bank financed government spending. It is not inconceivable that this is what central banks may start trying to do. We are seeing this by the BOE now giving preferential treatment to banks lending out and the ECB with its latest move.
Finally, negative rates could, as noted above, force banks to lever up to make money and it is not inconceivable that this could work in some countries where the banking system sounder or where some banks may have the buffer to do so. The main risk for the central bank is that this reduction in its balance sheet simply forces reserves into government bonds anyway as commercial banks see no other choice. The structural features of financial repression also will point towards this.
Here of course, the practicality becomes an issue. The BOE now holds 30% of all Gilts outstanding and if it started to sell these off as banks started to lend to the real economy interest rates across all maturities and lending products could rise very fast and in complete disconnection with underlying fundamentals. Currently, the position for central banks in this matter is complicated because as we have seen liabilities tend to migrate to the government balance sheet and as such the central bank needs to work very hard to keep borrowing costs in check for the sovereign.
Now, as for creating physical currency it is not clear to me that central banks would want to do this but the notes that I have read so far simply assume that it is given that commercial banks would be able to shift reserves into currency. This then brings up a whole hosts of other issues regarding the existence of cash at the zero lower bound. Citi's chief economist Wilhelm Buiter for example has suggested that physical currency be retired altogether and that electronic money be used instead. Such electronic money could of course be subject to exactly the level of negative interest rates the central bank deemed fit or perhaps even be subject to a fixed maturity.
Negative deposit rates have another effect in so far as they induce carry trades in with the negative currency yielder as funder and thus pushes the currency (euro) down. Such real effective depreciation could be a powerful tool for the ECB and for once it is a first mover here.
Ultimately, negative deposit rates are no panacea and certainly in the context of central bank creating the excess reserves in the first place, but the effect of FX markets as well as the potential for its effect on the quantity of currency in the system should be keenly watched.
There is still the strange feeling among many investors however that 2012 will be a repeat of 2011 and that sideways movement into the summer will eventually be released in another sharp draw down in global risk asset prices. As always, the extent to which this remains the consensus among investors even as monetary policy continues to ease in both conventional and unconventional fashion, Alpha Sources is getting more confident that bears may just get caught out.
It is important though to be extremely sensitive to the data at this juncture with key economies such as China and the US at obvious inflection points.
In the US and despite the visible deterioration of the data in the past month, the call for a recession is still at risk. An ISM at 49 is normally not associated with a recession and further deterioration into the mid 40s in July would be needed to give a recession signal. Still, global bond markets continue to predict a very dire future with more and more investment grade yields going into negative territory and anything generally assumed safer than handing over your money to a teenager in a department store, seeing bid. Still, I am skeptical that such signals from an essentially manipulated and stretched market are all they are made out to be and prefer to stay close to the real economic data for now. This week sees a big chunk of data releases as well as the Fed chairman is scheduled to speak, so watch out for direction. F
China Rising or Falling?
In the case of China, Prime Minister Wen recently warned that positive momentum is not yet visible in the economy. This suggests more stimulus is on its way beyond the two rate cuts already implemented.
But, is this bullish because monetary stimulus in China will lead the economy up and indeed lead a general continuation of the global EM easing cycle? Or is it bearish because it suggests that conditions in China are worse than expected?
Alpha Sources would lean towards the former, but unless the data starts to turn this remains a hope and perhaps even a fool's one as it depends on the authorities' ability to micro manage the economy. As ever, the discourse on China is stretched by unrealistic expectations. On the one hand there are those who believe that China is able to reach pre-crisis growth rates of 10-12%. It isn't and there is no doubt that many global commodity producers have too much capacity relative to the growth level that China is able to attain. On the other hand, the chorus of those calling for a hard landing and essentially a collapse of the Chinese economy has, at times, been deafening. Alpha Sources finds it difficult to see exactly why this is supposed to happen now. China may be headed for a big crash, but such things rarely occur on the back of and in the midst of extreme euphoria and not excessive pessimism.
Alpha Sources' base case scenario is that more stimulus from China will be able to drive positive sentiment forward, but also that between those calling for status quo and a crash, China is likely to achieve neither and in stead simply achieve a new trend growth level much lower than before.
Upside surprises in Europe?
Despite the perceived victory of the periphery in the recent EU summit Merkel remains resilient in her demand that if Spain and Italy eventually will need bailout, the price has to be considerable handover of sovereignty to EU and Germany on the fiscal side. This is a reasonable claim even if the message to the outside is that Spain will avoid direct involvement in sovereign affairs due to the technical nature of the bailout money being distributed to its banks.
Still however, the recent sharp reversal in the rhetoric by the Spanish Prime Minister Rajoy and the promise of yet another round of cuts come in nicely on the back of the market finally starting to see signs that perhaps even senior creditors of Spanish banks be forced to take losses. Alpha Sources welcome such realism by part of the periphery, but is still left with the bitter taste in the mouth from watching drastically different measures being applied to the little ones (Greece and Ireland).
In this sense, the ever eloquent Chris Wood is spot on in his recent juxtaposition between the situation in Spain and Ireland.
GREED & fear has been calling for losses to be imposed on subordinated bank bondholders for some time as the best way of imposing a loss, and allowing the capitalist system to start working again. It is, therefore, encouraging that this approach may actually be adopted as already discussed in the case of Spain as one of the Eurozone’s preconditions for recapitalisation, which by the way means a significant diminution in Spanish sovereignty. Still, given that so much of this subordinated debt has been sold to retail investors as savings products, such a policy is going to create a firestorm in Spain politically. It must, therefore, be wondered if the loss ends up being imposed anyway on the sovereign balance sheet of Spain as buyers of these products demand to be made good. The Spanish owners of junior bank debt may also wonder why he or she is being treated so differently from Ireland where the ECB seemingly forced the Irish Government not to impose losses on subordinated bondholders thereby putting the Irish taxpayer on the hook. GREED & fear would not like to be viewed as a cynic. But the difference could be that the Irish subordinated debt was owned by big institutional investors whereas in the case of Spain it appears to be the little guy.
Another case in point that I feel the need to elaborate on is Greece. Only two months ago did the consensus hold that Greece would leave the Eurozone or perhaps even that the country would be forced out. Alpha Sources always thought that this was mad and we know now that it was. The difference between the first PSI and the warmongerings from Merkel and the EU were clear.
In the case of the former, the risk was chiefly that Greece would not accept the terms under the restructuring (laid out by the IMF and the EU) and simply apply a unilateral haircut. In the case of the latter however, Greece was seen being in the corner pleading that the country would not want to leave but simultaneously also getting starved of essential liquidity to keep the country running.
Investors should remember that differential treatment between large and small economies in what has become a near perpetual bailout effort by part of the EU, the IMF and the ECB is a mistake that may eventually become the problem itself.
Finally, it is important to dwell a bit on the recent ECB meeting where not only the main refi rate was reduced but also, and much more significantly, where the deposit rate was cut to 0%. This marks the first major central bank trying to take a stab at the problem of a slump in velocity and essentially a broken monetary policy transmission mechanism. As such, bulging reserves without a corresponding pick up in lending to the real economy remains one of the main problems in the developed world (from the point of view of monetary policy makers that is). Sweden enforced negative interest rates on reserve balances in 2008, and now the ECB is essentially following in the Riksbank's food steps.
In this way and just as Alpha Sources has spent the last couple of days catching up with the news, so it seems that European policy makers with Spain now apparently open to imposing losses throughout banks' capital structure and the ECB delivering the boldest monetary policy step since the Fed opened up the QE bag in 2008, Europe may finally be catching up.