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Entries in Inflation (6)


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. 


Other Alpha Sources

I have been enjoying myself in the Austrian Alpes last week and hence the lower output. Here is my look though, of a number of notable news stories and contributions. 


Global Liquidity

Benoît Cœuré, Member of the Executive Board of the ECB has penned a speech (and argument) on global (excess) liquidity. Izabella likes it and I agree with her that it is a good piece. I am not sure though that it is that much different than the Savings Glut argument put forward by Bernanke, but I may be missing the fine print (i.e. need to read it more carefully). The biggest problem I have is that he assumes that the lack of safe government (i.e. AAA rated assets) is cyclical and due to market failure or other "temporary" factors. Izabella interprets it as follows, 

What’s the solution to this vicious liquidity circle? Simple, says Cœuré. The euro area needs to regain its role as a global supplier of safe assets. Something which could be achieved by a) ensuring that Eurozone countries have become fiscally sound and b) diverting excess liquidity from other zones back into “programme countries” by way of the IMF.

I disagree. The failure of euro zone economies and indeed large parts of the OECD edifice in general to provide "safe haven" assets is deeply structural and tied to population ageing. Unfortunately, there is little prospect that the euro zone economies will be able to supply AAA rated securities for a long time and herin lies the rub. Of course, if we are talking euro bonds, but then again. I will believe it when I see it. 


Japan and the currency wars 

A recent Bloomberg article suggested that Japan has been "secretly" selling JPY to try to stem the tide and force through depreciation of the Yen.

Japan used so-called stealth intervention in November as the government sought to stem yen gains that hammered earnings at makers of exports ranging from cars to electronics.Finance Ministry data released today showed Japan conducted 1.02 trillion yen ($13.3 billion) worth of unannounced intervention during the first four days of November, after selling a record 8.07 trillion yen on Oct. 31, when the yen climbed to a post World War II high of 75.35 against the dollar. The currency’s strength has eroded profits at exporters such as Sharp Corp. and Honda Motor Co., just as faltering global growth undermines demand. 

Open market operations to sell domestic currency are so old school. Didn't they get the memo in Japan? In a world where all major central banks are either at or very close to the zero bound, it is central bank balance sheet expansion (quantitative easing) that matters. On this note, both Japan and the Fed are being left decisively behind by the ECB and BOE (at least in the past six months). Of course, even the usage of "standard" measures in Japan is being contested and as long as this is the case, the Yen will continue to strengthen.


Don't bet on deflation with the current team of global central bankers 

Elsewhere, I am wondering where all the deflation, let alone disinflation, is. I am a sworn deflationist and I believe in the main thesis of the deleveraging/depression/deflation crowd. However, I have the utmost respect for the inflationist bias of global central banks and with the current batch of policy makers at the helm, deflation is a very remote risk.

The latest data show that inflation in China recently quickened as well as producer prices in the UK increased in the week that the BOE announced another round of QE. Of course, this is not all clear cut. Chinese real M1 (YoY) recently moved into negative territory for the first time since 1996 and in the UK, it is noteworthy that core inflation (ex food, beverages, tobacco and petroleum) came in noticeably lower in January. 

I will change my views on the basis of changing data, but I am beginning to think that the bout of global headline disinflation we are expecting as a result of the global slowdown will reverse itself much, much quicker than many (including me) have expected. Arguably, we still need decisive easing in emerging markets and QE3 from the Fed, but it is more a matter of when and not if this happens and as such, global central bankers remain fully committed to creating inflation.

The main problem so far for those arguing for strong central bank action (including me) is the absence of nominal growth in output in excess of consistently rising headline inflation. Could this be a result of doing too little, perhaps, but at the moment stagflation remains the best way to describe our current economic situation and thus inflation in all forms is a drag on growth. Should the genie finally come out of the bottle in the form of consistent wage increases central bankers may find that they got more than they bargained for even if the alternative is equally painful.  


The Greek experiment is about to end

Greece remains the main talking point and also the only thing that appears to prevent equity markets ripping to new highs. Greece is bankrupt and while I understand that the patience of the rescue committee will run out at some point, I am astounded that anyone expects this hideous experiment to end well. Greece will see its fifth year of contraction this year and for what? A membership of a currency union that does not work anyway?

We are told by the Troika, the EU and the IMF that failure to reach a deal would be catastrophic and thus that Greece has no way out but to take the medicine. However, Greece has a real choice and the stronger she is pushed the more obvious the end result is. Internal devaluation and decades of austerity don't work; not in Greece and not elsewhere. This remains the KEY issue that the euro area politicians and the ECB have not understood. The social fabrics of society won't stand the pressure and strain. Textbooks tell us that the cure is simple when you can't devalue, but practical experience have now shown otherwise. 

I am neither on the Greeks' nor the IMF/Troika's side, but I simply point out the obvious destiny of current events; failure! Even if Greece manages to appease its creditors with austerity, the end result in terms of Greek macroeconomic balances is still unsustainable and thus the underlying problems will not have been solved.

The ECB and the IMF will likely face significant drawdowns on their Greek bondholdings regardless of whether they use such drawdowns as  "carrot" for Greece to push through austerity measures. This is what the establishment has not yet understood.  


MF Global investigation fails to uncover illegal activity?

Megan McArdle has an amazing article suggesting that the investigation on the failure of MF Global is finding it difficult to uncover anything illegal. 

Megan quotes a piece from Reuters (no link available)

Lawyers and people familiar with the MF Global investigation of the firm that was run by former Goldman Sachs head Jon Corzine say that even though the hunt is still on to find out whether or not officials at MF Global intended to pilfer customer money in a desperate bid to keep the brokerage from failing, the trail at this point is growing cold.

This seems very odd to me even if I have not followed the aftermath in detail. I completely agree with the sentiment expressed by Megan

I don't understand how this could be true. To be clear, I am not saying that it couldn't be true-only that I don't understand how such a thing could have happened. There is more than a billion dollars missing from supposedly segregated client accounts. I understand that it was chaotic, but what kind of chaos causes you to accidentally move money out of money that any moderately sophisticated compliance system should have automatically flagged for approval?

While my professional responsibilities are confined to the smooth running of a macro research product I sit in an office, and work, with asset managers and ever since the failure of MF global I would imagine that their general level of concern has increased. This is understandable. If your main counterparty as an asset manager (i.e. your prime broker) essentially decides to steal your deposits and/or allocate them to losing trades against the principle of segregated accounts, it really does not matter what you do. No matter the tightness of the shop run on the asset managers' end, he will face significant and perhaps even fatal losses. 

Obviously counterparty risk is as old as finance itself and any decent asset manager today will deal with more than one broker and even have a strategy on how to manage counterparty risk. Ultimately though, mutual trust between asset managers and their prime brokers is a commodity which has been severely impaired by the MF Global failure and this is an issue for all players in financial markets. 


Dealing with vintage data in economic forecasts using instrument variables (wonkish!)

A recent note from the George Washington University points to an interesting study from Warwick University on the forecasting of data vintages in the context of US output and inflation forecasts. The problem is as follows; 

Consider a simple benchmark autoregressive model that a forecaster might use to forecast an economic variable yt. In order to estimate the parameters to be used for the forecast, typically the forecaster will obtain the most recently updated data on yt (i.e. the vintage of yt available at that time) and estimate the model using those data. However, the data in this single time series may in fact be coming from different data generating processes. The data some time back in the series have gone through monthly revisions, annual revisions, and perhaps several benchmark revisions. The most recent data, however, have been only “lightly revised,” as Clements and Galvão term it. Therefore, Clements and Galvão argue that the data in a single vintage are of“different maturities.” Forecasters may want to forecast future revisions to data as well as exploit any forecast ability of data revisions to improve forecasts of future observations. In their article, Clements and Galvão suggest that a multiple-vintage vector autoregressive model (VAR) is a useful approach for forecasters working with data subject torevisions. This comment discusses the importance of taking revisions into consideration and compares the multiple-vintage VAR approach of Clements and Galvão to a state-space approach.

This is a significant issue but remember; if the following holds, we need not worry too much about it. 

If the revisions are unpredictable and the early data are efficient estimates of future data, then we may not need to be concerned about the different vintages. 

Most economists assume that the statement above is true and simply force through their model. Being a great believer in practical usability when it comes to empirical economics, I would argue that in most cases this will not cause too many problems in most cases. However, a growing body of evidence suggest two important issues to consider. Firstly, revisions are predictable and thus provide important ex-ante information which should be incorporated into the the forecast. Secondly, even if revisions are unpredictable, the manner in which data is revised may itself provide important information on future data readings. 

I agree, but the problem is potentially much more severe. Another issue then concerns that situation where you try to forecast Y(t) as a function of X(t) where both variables may be subject to revisions. Normally, we would solve this issue by restricting X(t) to variables where revisions are minimal (or absent alltogether). One way to do this is to use market based data (market prices, closing values of securities etc) which are, by definition, not revised. However, in the context of the e.g the classical leading indicators framework pioneered by Geoffrey H Moore, this issue re-emerges X(t) is cast in the form of real economic variables (themselves potentially subject to revision).

We have replicated and refined many of the LEIs described by Moore et al and applied it to various economic data series with specific fitting of a time series regression in each case. However, such an approach may still suffer from vintage data issues (as described above. One solution that I been thinking about is to imagine two forms of right hand variables. X(t, economic) and X(t, market based); if the latter is unrevised it might be possible to find an instrument for X(t, economic) (final revision!) using a variation of X(t, market based). This would, in my opinion, constitute an elegant way to solve the issue of data revisions in your explanatory variables.

In practice, you could also try to replace Y(t, economic) with Y(t, market based), but this is probably too a-theoretical and ad-hoc.