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Entries in ben bernanke (4)


In Bernanke we Trust

Do you feel it too … The air of complacency that has engulfed financial markets and policy makers in the last month. With inflation falling and even the spectre of deflation now returning as a market meme as well as stubbornly weak growth, more stimulus and less concern about debt and deficits might of course seem warranted.

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. 


After Jackson Hole, Clear Road Ahead?

In terms of forward guidance I think the Fed Chairman's speech provided little direction, but Friday's precious metal price action into the close and the various sell side notes that I have seen suggest that this, at least initially, is too bearish a conclusion. The following excerpt from the speech, in particular, was taken as clear evidence of more and aggressive easing in the pipeline. 

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. 


Random Shots - Smoke Screens

First off obviously; Spain and the country's bailout which was announced yesterday. Alpha.Sources is amazed that it has not happened before really. As we have seen so often before when Europe is on the brink of disaster this time with a Greek exit looming and Spanish banks in tatters, a response has been cooked up in the fudge factory. 

Spain asked euro region governments for a bailout worth as much as 100 billion euros ($125 billion) to rescue its banking system as the country became the biggest euro economy so far to seek international aid.“The Spanish government declares its intention of seeking European financing for the recapitalization of the Spanish banks that need it,” Spanish Economy Minister Luis de Guindos told reporters in Madrid today. A statement by euro region finance ministers said the loan amount will “cover estimated capital requirements with an additional safety margin.”

With Greece the immediate danger only a couple of weeks ago, the failure by Bankia seems to suddenly have alerted the eurostriches to the vortex of capital destruction in the Spanish banking system and the inevitable bailout got the fast track rubber stamp. 

Two points are interesting to focus on initially here. 

Firstly, the headline number of €125 billion is big, really big. Only a couple of weeks ago we were hearing numbers of a €20 to €30 billion euros for Spanish banks and this underscores just how expensive this may turn out to be. Consequently, we don't really believe that this is going to be the final number now do we?

Looking at mortgages alone, the accumulation of negative equity by households may rack up a total tally of more than €250 billion euros and this does not include property developer loans. Spain decided early on to attempt to let time be a healer and assumed that losses could be taken over time without the market catching on. This weekend's events show us that this is not possible and I think that the final number will have German and IMF accountants working over time to figure out just exactly where the money is going to come from. A corollary to this point is the also that the EU badly needs to sort out the firepower for the EFSF and the ESM since the original structure simply won't have to capital to sort out Spain and cannot, in its current form, simply access the market for more.

Secondly, the battle of numbers mentioned above seem initially to have taken the backseat to the discussion of whether in fact Spain has gotten a bailout or simply a very cheap loan by a willing lender.  Finance minister Luis de Guindos plays the part well. 

“The financial support will be directed to the FROB [Spain's Fund for Orderly Bank Restructuring] which will inject it in the financial entities that need it,” said finance minister Luís de Guindos in a press conference this afternoon. “It is a loan with very favorable terms, much more favorable than the market’s. In no way is this a bailout.

Obviously, this is nonsense but we must understand that this is a critical discourse to push for Spain. Every single country that has so far received an EU/IMF bailout is dead in the water either now effectively under permanent stewardship of a troika or simply in some form of default. In this light, Spain has a distinct interest in pushing the story that this is not a bailout, but my feeling is that this weekend may have marked the last time for a long while that the Spanish sovereign has accessed the market on normal market conditions. 

In this sense, yours truly certainly agrees with Edward. If it walks like one and quacks like one and all that. 

“Of course it’s a bailout. What else would you call it? If you can’t finance your debt, and you have to ask someone else to finance it, it’s a bailout. But everybody who’s taken a bailout is dead, and Rajoy doesn’t want to be dead."

Still, while Edward may have the right point here there is a finer point to be made. The higher the EU/IMF bailout efforts reaches up through the pecking order in the peripheral economies the weaker Germany's and the EU's hand becomes. You can just imagine the discussion about conditionality with Spain withRajoy et al simply pointing out the obvious in terms of a complete meltdown of the euro zone economy in the even of an un-managed unravelling of the Spanish banking system. 

The smoke screens will be blown thick and fast from Madrid, but the initial spin is very easy to predict. Spain's problems, we will be told, reside in its banks and therefore the government needs less supervision relative to Greece where the government is the culprit. As Lisa Abend puts it (article linked above), 
Any European and IMF oversight–the latter will not be contributing funds but will be involved in monitoring their use–will be restricted to the financial sector, not the Spanish macroeconomic system as a whole.

This is absolute tripe of course.  One of the main lessons of this crisis is that in the case of a highly risky stock of private debt in the private (banking) sector it is only a matter of time before this liability must be assumed by the sovereign (Ireland is an example here, but Australia and Denmark exhibit similar characteristics).  One would expect Spain to continue playing this implicit card of systemic importance in order to starve off the stigma of bailout. Naturally, this is grossly unfair for Greece which is being submitted to chemotherapy even as there is a 50/50 chance that the treatment itself will kill the patient. This is is especially the case if the ECB/EU end up chucking the country out through a stop of the ECB liquidity life line. 


Reality Creeping up on Japan

Of the deluge of news the past couple of weeks, what caught Alpha.Sources' attention was how the Bank of Japan pushed back against increasing government cries for more monetisation. 

BOJ Deputy Governor Hirohide Yamaguchi said the central bank will not rule out further easing if risks in Europe materialize and exert strong downward pressure on Japan's economy. But he signaled that Japan will likely achieve the BOJ's 1 percent inflation target without further monetary easing steps, saying the bank's stimulus measures in February and April have heightened the chance the economy will resume a recovery.

A sign of the times perhaps that central banks are starting to feel the pressure from the very guardians of their assumed independence to do more, and to do it more aggressively. As always it will be difficult for central banks to do much since ultimately that would involve biting the very hand that feeds them.

Still, it was refreshing to hear the governor Shirakawa rise above the relationship with the ministry of finance to link Japan's chronic deflation problem to the country's ageing population. If only leaders and economists in Europe would listen to this rather than the consensus that has now emerged that a euro breakup and exit is now the inevitable outcome.

Another interesting structural force which seems to be at play in Japan is the fact that the trade balance may never swing back into surplus due to the dependence on energy imports. Primarily LNG imports tied to the oil price on long term contracts. Alliance Bernstein estimates in a recent note that of the Y1 trillion increase in imports since April 2010, about Y700 billion has come from LNG imports which has replaced the country's idle nuclear capacity. As such idleness is likely to be structural so will the persistent trade deficit likely become structural. 

We should remember however that Japan still runs a substantial current account surplus as a result of a positive income balance derived from the world's largest positive net foreign asset position. Still, the current account surplus is shrinking fast coming in at only 2% of GDP in 2011 which is the lowest in 12 years. As suhc, despite Mr Shirakawa believing that the BOJ has done enough, the onus on the central bank rises to start monitising government debt less Japan wants to peddle bonds to foreigners in which case reality would instantly catch up the Japan's government finances. 


Deflation Risks Re-Emerge with a Venegance, but Central Banks Prefer Stagflation

Moving on to the market, my dear reader we are at it again. Europe is once again on the brink of disaster with a Greek exit looming and Spain all but certain to seek the inevitable bailout. As so often before, starting up the fudge factory seems to be the most likely outcome , but could this time be different? 

A number of heavy weight columnists have recently (yet again) proclaimed that the end of the world is nigh. Most devastatingly was of course Raoul Pal's End Game presentation which gives investors a mere 6 month to protect themselves before heading for the bunker. 

In addition, Soc Gen's Albert Edwards also recently touched on the growing and most disconcerting disconnect between global stock markets and all time low (and even zero or negative) bond yields in the developed world. 

As 30y German Bund yields slide below 2% and rapidly converge towards Japanese rates, we have a taster of what is to come in the US and UK in the months ahead. We still see US 10y yields even now making new all-time lows falling below 1% as hard landings occur in China and the US. The secular equity valuation bear market began in 2000 and renewed global recession will be the trigger to catalyse the third and hopefully final, gut-wrenching phase of valuation de-rating. Expect the S&P500 to decline decisively below its March 2009, 666 intra-day low. All hope will be crushed.

And in his latest flash comment, Greed and Fear (Chris Wood) also alerts investors to the threat of deflation. 

The consensus monkeys have been proved wrong yet again. A mere three months after talkingheads on the sell side were doing their usual annual first quarter ritual of proclaiming the endof the “secular” bull market in US treasury bonds, the ten-year bond yield made a new all-timelow of 1.45% on Friday. 


It continues to amaze GREED & fear how most analysts in the West continue to underestimate the deflationary structural forces at play and are always trying to pick the peak of the bond bull market (in price terms) and the commencement of inflation. Still the main reason GREED & fear has so far avoided succumbing to this temptation is that GREED & fear has been observing Japan for more than 20 years. And for GREED & fear, and for anyone else who has been watching Japan for a similar period, the market action in the West since the global financial crisis hit in the summer of 2008 does not surprise. Rather it remains eerily familiar.

Alpha Sources is concerned, as ever, that a wash-out is coming and certainly remains in the structural deflation camp in so far as goes global debt and growth dynamics writ large. It is also the contention here that it remains a widowmaking trade to call the end of the bull market in bonds, that would require much a much more sinster involvement of bond vigilantes from whatever hole they might appear.

However two points are worth noting.

Firstly, G&F's comparison with Japan may only be as good as it goes. While the blueprint is the same and there central banks have woved no to repeat the Japanese experience. The stated intention of central banks remain to print when it doubt. 

Nowhere is this clearer than with Bernanke. The Fed chairman has demonstrably stated his intention not to travel down Japan's road to deflation. Could it be that this commitment in itself will lead us to an alternative outcome? As always, the proof will be in the actual effect of additional monetary and fiscal stimulus where I would note that in past periods of QE in the US, bond yields have increased! Then there is of course the BOE where Mervyn King and his council have been extremely aggressive in their efforts to combat perceived deflation risks. 

Secondly, on the scenario laid out by Albert Edwards,  one has to note that the stock market is essentially just a nominal price and nominal prices can be manipulated by authorities. While Edwards clearly believe that we are heading towards a situation where this is impossible, Alpha.Sources would be weary betting on a fallout in the S&P 500 to the 500s before the Fed's toolbox has been completely exhausted. Negtive interest rate on excess reserves as well as outright unsterilized purchases of financial assets are the likely next steps if things go south from here. 

But, as always, Edwards is on to something. As stock markets ran up in the aftermath of the ECB's LTRO yields stayed pinned to the floor. When and how aggressively would yields catch up to the stock market? Well, it seems now that we know the answer to this question; the market may just be about to catch up with falling bond yields even if the latter remains severly oversold in the short run. 

We are now in a situation where developed government bond markets still considered safe are pricing in a calamity, but it is important for investors to understand that such apparent grave "expectations" are amplified by the very nature of post crisis financial markets where government bond markets across the European periphery are considered nothing but a very risky equity investment (due to the implied subordination to an ever growing size of the institutional (ECB and IMF) sector involvement in this market). 

In this sense, there is a considerable fundamental mispricing mechanism being operated at the current juncture where normal discounted cash flow valuation analysis cannot be used to explain why anyone would want to pile into government bonds. Or put differently, there are many reasons to hold government bonds and the discounted return from holding to maturity is not necessarily one of them. Liquidity and preservation of the face value of capital are much more important in the current climate even to such an extent that investors are willing to pay a premium for the return of their capital at a later date (negative interest rates). 

In the US for example, it is not clear to Alpha.Sources for example that inflation expectations in the US are pricing in stagflation rather than deflation. This makes sense if we believe in Bernanke's commitment. Of two evils, the Fed appears to prefer stagflation over deflation and it will make sure that faced with such a binary menu, the former is what materialises. 

In the short run, the stark drop in US payrolls may give direction with equities likely to correct downwards towards what the bond market has been telling us for a while rather than the other way around. But ultimately and while Alpha.Sources is weary of the threat of deflation, it is important to show significant respect the playbooks of central banks. Evidence has taught us not to underestimate the ruthlessness by which central bankers are ready to provide inflationary stimulus and as such Alpha.Sources will be hesitant to claim, unlike in the case of Spanish politicians, that they are blowing smoke screens.