Trading places

Though the signal from central banks was relatively subtle, expectations for another round of QE in the US and UK took a decisive shift yesterday.

Here's the words that triggered this move:

- 'The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed' (FOMC policy statement.)

- ‘For some members, the probability that further action would become necessary to stimulate the economy and keep inflation on track to hit the target in the medium term had increased’ (MPC September minutes)

While this doesn't make QE2 inevitable, it’s exactly the kind of shift in tone City analysts have been waiting for. Some are now forecasting QE in both economies as early as November. (e.g. Goldmans for the US, RBS for the UK.)

The resultant rally in bonds isn't surprising - further asset purchases should directly depress yields. Perhaps the limited/slightly negative reaction in stocks is more disturbing. Either equities already had further stimulus priced in (which is possible given their recent resilience) or investors are becoming more sceptical about the effectiveness of such policies.

Macro Maestro has expressed his concerns about the effectiveness of QE2 before. For now he'd just like to point to this. According to the FT, the Fed is going to try BoE-style QE (buying bonds). But last week, the BoE suggested further stimulus would come from Fed-type credit easing. So both central banks are ditching the QE they tried before and switching to the other's previous favourite. Does anyone else find this slightly disturbing (and ironic)?

Margins of error

In response to Macro Maestro's earlier post, several people gave the same response - equities' resilience makes sense because of corporate cost-cutting. (This also seems to be the argument being touted around by strategists at Citi.) They point out that during the recent recession, the US profit share increased sharply as companies slashed wages and employment. A double dip - consistent with current bond yields - would allow this process to continue, justifying current equity valuations.

This argument seems ludicrous to Macro Maestro. Yes, profit margins can rise during a recession but it's hard to see this continuing indefinitely when nominal GDP (the main determinant of profits - look at the historical correlation) is extremely weak for a prolonged time. (Profits growth roughly equals nominal GDP growth plus the change in margins.) So Macro Maestro thinks recent US profits performance is a short-term 'levels effect' as companies eliminated the inefficiencies that built up during the boom years. The US profit share is already close to its cyclical peaks and Macro Maestro finds it hard to believe this will rise further, especially if top-line earnings (nominal GDP) collapses.

Plus Macro Maestro doesn't recall Japanese corporate profits or equities performing too well during its 'lost decade'.

Dislocated

During the summer, bond and equity markets started to diverge:

10-year yields in many advanced economies (including the UK, US and Germany) fell to their lowest levels since the depths of the financial crisis (and in some cases their lowest levels on record), while equity prices have generally held up. Of course, there are a few exceptions to this, notably within EMU (Greek, Irish and Portuguese yields have risen back towards their May 2010 peaks).

Such sharp divergences between bonds and equities are unusual. Early 2008 was the last time this occurred, when the yield curve inverted (signalling recession) and stocks tried to shrug this off. Macro Maestro remembers talking to investors at the time and there were stark differences in opinion, even within the same financial institution. In general, ‘bond types’ were talking about deep recession, liquidity traps and even depression while equity investors believed the sub-prime crisis would be relatively contained. (We know how that worked out..)

This time there seem to be several possible explanations:

1.       Perhaps the most benign possibility is that central banks are depressing bond yield by talking about further monetary stimulus. Another round of global QE should depress bond yields and, if successful, support future growth (and hence equity valuations). As evidence, we should note Ben Bernanke set out the Fed’s remaining policy options in an August speech. Goldman Sachs are now forecasting another round of US asset purchased by the end of the year.

2.       Some claim the bond market is a better leading indicator that equities. In this scenario, the global economy is about to experience a ‘double dip’ recession and the equity market is simply mispriced. This was the case in 2007-08. Still, bond investors seems to be taking a significant gamble. Recent US data have been soft, but certainly not at recessionary levels. (Euro-area indicators are still consistent with above-trend GDP growth.) Current levels of yields seem more consistent with a Japanese-style deflationary environment – this is certainly not something Macro Maestro would be comfortable forecasting with such conviction, particularly as it relies on the complete breakdown in private sector confidence. (Is such a thing forecastable?) Still, the recent decline in 10-year spot yields (at least in the UK) does seem to have been driven by the inflation expectations component (see chart below – based on BoE data):

3.       There is a bubble in bond markets. After a two-decade rally in bond prices, investors are getting carried away and buying bonds purely as a momentum trade. A minor example of this occurred in late 2002, when the original Ben Bernanke ‘plan B’ speech triggered a sharp, temporary drop in bond yields. As it turned out, deflation concerns were largely a hoax.

Macro Maestro isn't convinced by 1. With the exception of Goldman's Jan Hatzius, most investors/economists reacted to Bernanke's speech with a 'is that it?'. So that leaves 2 or 3. Macro Maestro belives 3 is a more compelling explanation than 2 - the bond market's utter conviction in deflation is difficult to justify. But that doesn't mean Macro Maestro isn't worried about the global growth outlook..

Basel Faulty?

(Macro Maestro couldn't resist this rather obvious title, even though he is generally in agreement with yesterday's regulatory announcements.)

On Sunday, the Basel Committee on Banking Supervision said it had finally agreed new capital requirements, which would be phased in over a number of years. (Largely to keep the Germans happy - what does this say about the state of their banking sector?). The headline was a rise in the minimum Tier 1 capital ratio from 4% to 6%, plus a new 'conservation buffer' of 2.5%. (Tier 1 capital is broadly shareholders' equity - the original purchase price of stock - plus retained profits minus cumulative losses.)

The 'conservation buffer' forces bank to hold additional capital as protection against unexpected shocks. If banks fall within this buffer they will face restrictions on dividends and bonuses. Officials don't want markets to regard this additional buffer as part of the new minimum, but it's hard to see how this can be avoided. So the minimum requirement effectively jumps from 4% to 8.5%.

Then, there is a new 'countercyclical' capital buffer. This means when credit is growing strongly, the conservation buffer widens further. At the height of the credit cycle, this would push the effective minimum capital requirement up by a further 2.5% to 11%.

These are big changes, so what do they mean? Macro Maestro will leave market strategists to work out the impact on the banking sector overall. But the reaction from the market so far is positive, with bank stocks jumping sharply. Presumably, this means either these regulations were less onerous than some had feared, or investors are celebrating the removal of one important source of uncertainty. (Pity about all the others..)

Still, Macro Maestro is more interested in the impact on financial stability. Here, he is reminded of two important pieces of research:

First, in its Q4 December 2009 Financial Stability Report, the Bank of England analyzed past financial crises to discover what they implied about the needs of future capital requirements. [Sweden, (1990-93), Finland (1990-94), Norway (1988-92) and Japan (1992-2004). Their work suggested Tier 1 capital ratios of around 8.5% would have been required to prevent government capital injections during those crises - bang in line with the new Basel minimum. This suggests to Macro Maestro that the new minimum is broadly right and certainly a vast improvement on what we had before.

Second, a UK FSA paper found a countercyclical capital buffer could have powerful macro-prudential advantages by damping the lending cycle. They found a 3% point increase in capital requirements (broadly the buffer agreed by Basel) would reduce private-sector lending by around 5% after 3 years.  This isn't a huge effect, but it might well be stronger if matched by tighter regulations in other countries (a global multiplier?). At the margin, this would have helped in the period 2005-07. But Macro Maestro believes policymakers should also introduce other policies to properly damp the credit cycle (eg higher interest rates even if inflation is low, stricter loan-to-value controls on mortgages).

Of course, we still need to know more on the detail (particularly when it comes to the countercyclical buffer) but to Macro Maestro these reforms seem to be moving in the right direction..

Fed up

Ben Bernanke is having a tough time. In July, when he presented his semi-annual testimony to Congress, he was heavily criticized for not outlining a plan B. Investors wanted to know what he would do to get the economy moving again if it fell back into recession. So, in August (at Jackson Hole), he duly obliged and explained in some detail the Fed’s policy options. These included: (i) further asset purchases, (ii) committing to keep policy rates low (conditional on economic developments or for a set period of time); and (iii) reducing the interest rate the Fed pays on bank reserves.

This did little to sooth market nervousness. Commentators noted, not only did these options seem a little underwhelming, but Bernanke himself was keen to outline their limitations. Macro Maestro shares this scepticism, but he understands Bernanke’s cautious approach. The Fed Chairman is still clinging to a view of the economy that does not require further stimulus. Perhaps he was hoping data over the next few months would make such a policy discussion redundant, reducing the risk that by outlining these options he further undermines confidence.

Unfortunately, activity data seems likely to remain weak and underlying inflation readings will probably subside further. So it’s important to start to debate about Plan B. There are some, notably in Europe, who are opposed to these policies because they involve taking risks with central bank credibility. There is even a hint of this in Bernanke’s discussion, when he points out that these policies might complicate the Fed’s exit strategy. Macro Maestro doesn’t really share these moral concerns and certainly doesn’t believe they will be a constraint on US policy. (It’s a different story in the euro area.) If the Fed genuinely starts to fear deflation, it will be willing to try anything to avoid it. (Note Bernanke explicitly didn’t rule out raising its inflation target – equivalent to central bank suicide – if the situation deteriorated far enough.)

Macro Maestro’s concern is whether the existing policy options will prove effective. Certainly, there seems little scope to employ Bernanke’s proposals (ii) and (iii). Markets already believe the Fed will keep interest rates on hold for a long time into the future, so there seems little benefit to explicitly saying so. (Especially as they’d probably make this commitment conditional on the economic outlook – the bond market has formed its own view on the economic outlook). And with the interest rate on reserves already at 0.25%, there seems little scope to reduce it further. As Alan Blinder points out, they could make it negative and charge banks for holding reserves but this seems unlikely to provide a powerful impetus for private-sector lending.

That leaves asset purchases. Macro Maestro’s is sceptical about asset purchases because he notes the UK experience. While admittedly we don’t know what would have happened in the absence of Quantitative Easing (QE), even a relatively large asset purchase scheme (purchasing over 20% of the outstanding gilt stock) seems to have done little to boost money supply or private-sector lending in the UK. Asset prices did recover, but only in line with other major economies. That is not to say QE had no effect. Macro Maestro believe the first wave of QE (globally) played an important role in supporting private-sector confidence in early 2009, when many feared monetary policy had already run out of options. But this was largely a confidence trick. If policymakers must resort to another round of asset purchases, Macro Maestro isn’t convinced it will trigger a similar shift in sentiment. And the reaction to Bernanke speech, certainly compared to the reaction this same speech had in 2002, suggests markets have alrady become more sceptical.

Big dipper

Returning from a two week vacation, Macro Maestro notes little has changed during his time off. The ECB and the BoE remain firmly on hold, the Fed is still talking about a new round of quantitative easing (while desperately hoping they wont need it) and the main issue for investors remains the strength and sustainability of the US economy. Friday's US payrolls report helped stiffen equity investors resolve, but other data have been decidedly weak.

Still, the debate about 'double dip' in the US, to Macro Maestro at least, seems to be missing the point. In particular, some economists last week argued a US double dip isn't likely because the parts of the economy that usually push GDP growth negative - notably housing and inventories - are currently so weak, it's hard to see them creating a drag large enough to pull the rest of the economy down. Macro Maestro doesn't take comfort from this kind of analysis. The debate is not whether the US will contract at some point in the remainder in 2010, rather it's about the underlying strength of the economy in 2011. If economic activity remains lacklustre, as Macro Maestro fears, then the US is still risking a Japanese style fate (and recent impressive data in Europe wont last). Worse, policymakers seem to be running out of ideas to get the recovery started again. And that means equity markets - which are still hoping for sustained economic expansion - would be woefully mispriced. Sharp falls in stock price could put us back to where we were in early 2009 (but without the hope of a V shaped recovery that lingered back then..)

(Macro Maestro's vacation didn't do anything to cheer his mood about the global outlook.)

Vacation

Macro Maestro is now on holiday until early September.

American sucker

American Sucker tells the true story of David Denby, the New York film critic, who got a little too caught up in the late 1990s tech bubble. After splitting up with his wife in early 2000, Mr Denby liquidated most of his family’s assets and invested them in tech stocks. With prices rising rapidly, he became completely obsessed with the ‘new economy’ boom – religiously watching CNBC, attending conferences, and striking up personal acquaintances with Henry Blodget (the former Merrill Lynch tech analyst) and the biotech entrepreneur Sam Waksal (who was eventually jailed for corruption). Like the Titantic movie, the ending is entirely predictable – he loses a fortune – but the book still provides a valuable insight into asset bubble psychology.

As the market began to fall, Denby was convinced it would bounce back. Occasionally it did, but not for long. So he hung onto his tech stocks until the very end of the downturn, by which time many of them were worthless. Unfortunately, he couldn’t accept the market was largely a bubble because he could see evidence of the ‘new economy’ all around him – computers were everywhere and communications were changing rapidly. In some ways of course, he was right. The data show the US economy genuinely changed in the late 1990s – unemployment fell dramatically without triggering rampant wage inflation, productivity accelerated significantly and, once companies focused on exploiting all the efficiency gains (ironically, after the bubble had burst), profits eventually reached a record share of national income. But, as in many bubbles, the market took an idea with some fundamental basis and simply got carried away.

While such excesses are no longer obvious in equity markets, Macro Maestro thinks you can see signs of this bubble mentality in other markets – notably the bond market. Right now, it is certainly hard to get too worried about inflation. Most major economies are running large negative output gaps and Asian exporters, concerned about maintaining market share at a time of low growth and a weak dollar, are still cutting their prices in the West. But the absence of high inflation does not imply – as the bond market seems to be assuming – that deflation is inevitable. Yet, a US ten-year yield of 2.5% seems to be pricing exactly that. And more subtlety, the momentum (and commentary) in the market seems to suggest investors are buying bonds purely because they think yields will continue to fall. This is the same basic psychology behind all bubbles and it was certainly apparent in the late 1990s stock bubble. Bond investors should also remember, of course, the state of public finances in the US and UK. Surely these warrant some kind of risk premium on the paper they are buying?

Macro Maestro doesn’t expect global deflation, but he does see another 12-18 months of weak growth and low inflation. This alone will generate significant volatility in financial markets. Most investors currently seem to have a bimodal view of the world - they are asking only whether we face deflation or inflation. As always, somewhere in-between these two extremes lies the most likely outcome. So, as the news fluctuates and investors' expectations flicker between these two scenario, asset prices will be volatile and there will be plenty of opportunities for the savvy punter to make money. (As long as they don't get drawn into dangerous momentum trades.)

Ménage à trois

Comments from Fed member James Bullard suggest the Fed, like the BoE, could soon have a three-way split. (Assuming Hoenig continues to vote for rate rises). This is becoming like the old economist joke about hiring two economists and getting three different points of view. So why have such extreme differences in opinion on these committees emerged? Macro Maestro suggests its a case of:

1. Huge uncertainty about the outlook. Though growth has slowed in line with what most commentators were expecting earlier in the year, it's incredibly hard to work out whether this is just a 'soft spot' or something more sinister. (Macro Maestro suspects the latter.) The economic models used by policymakers failed to predict the recession, so they are understandably reluctant to use them to try to forecast recovery. As these models have broken down, any existing consensus has fragmented.

2. Quantitative Easing has made it difficult to judge how loose current monetary policy is and what effect it is having on the wider economy. Some policymaker believe monetary conditions are so expansionary they are risking asset-price bubbles and further financial instability (eg the Fed's Hoenig and the BoE's Sentance), while others argue policy isn't yet doing enough. In the past, it was sufficient just to draw a Taylor rule to figure out the stance of monetary policy, but now with rates at zero, such analysis has become largely redundant. Most Taylor rules would now point to negative nominal interest rates. While QE might be equivalent to negative nominal rates, there is no way to judge how far negative.

This all points to a further period of inactivity from the Fed and the BoE. Unless of course, these economies slip back into recession. Then these differences in opinion would evaporate and central bankers will once again be united in doing everything they can to get their economies moving again.. And this time they might need to try something extreme. (See my next post.)

Convergence criteria

Macro Maestro was struck by the way some parts of the media interpreted last week's Euro area GDP data. Several influential commentators argued the large differences in GDP growth, say between Spain (+0.2% QoQ) and Germany (+2.2% QoQ), showed the euro area was 'continuing to diverge'. On the contrary, these data suggest the euro area is finally converging. While we should welcome this from a longer-term persective, unfortunately it's going to involve some pain for a while longer.

Developments in unit labour costs drove the underlying divergences within the euro area over the past decade. With the ECB setting policy rates for the whole region, real interest rates were simply too low for the likes of Spain, Portugal, Greece and Ireland (because of their higher inflation rates). This triggered rapid growth in house prices and huge, ultimately unsustainable construction booms. Employment in those sectors surged, their labour markets tightened and real wages grew out of control.

Higher labour costs made these economies increasingly uncompetitive - their real exchange rates appreciated, notably against Germany. (German companies were still trying to restore their competitiveness following reunification in the early 1990s - an event that, because of the way it was managed, turned a healthy current account surplus into a huge deficit.)

In the past, euro area countries would have addressed their competitiveness problems by devaluing their currencies. But being part of EMU, this is no longer an option. Instead, these economies are going to have to restore competitiveness the hard way.

The latest data suggest this convergence process is now underway. The financial crisis popped the housing bubbles in these smaller euro-area countries, unemployment jumped higher and wage pressures are finally starting to ease. So far, it seems Ireland has made more progress than Spain - largely because the Irish labour market is more flexible.

The bad news, unfortunately, is that this process has a lot further to run. Though construction employment (as a share of the total) has now returned to pre-boom levels, real exchange rates still seem too high for many of the smaller euro-area economies. Until they are lowered, unemployment in these countries seems certain to remain high (and perhaps rise further). In turn, falling real wages should continue to depress consumer demand and aggregate GDP. So GDP data will diverge, as the press point out, but the underlying health of the euro area (and the ECB' ability to manage it) is arguably improving..

2003 rate oddity

Kansas City Fed President Thomas Hoenig argues the FOMC is making a mistake by not raising interests rates. He worries the Fed is making the same error it made in 2003, keeping interest rates too low for too long and encouraging asset price bubbles. Andrew Sentance has made similar claims in the UK.

Macro Maestro doesn't find this argument too compelling, for several reasons. First, temporary factors - particularly falling import prices- temporarily depressed inflation in 2003. Investors and policymakers  misunderstood these trends and assumed they would continue, triggering a deflation hoax. Even if inflation was about to turn negative, it would have been a relatively benign type of deflation. The situation now is more disturbing - huge negative output gaps in the West are forcing inflation lower and this trend seems likely to continue. Moreover, the private sector is still deleveraging, trying to rebuild its balance sheets and pay back debt. Falling consumer prices, which would raise the real value of existing debts, would be far from benign.

Second, even if central banks are currently inflating asset prices, this is not being matched by rising indebtedness. Bursting asset-price bubbles usually only have important real economy consequences if they encourage debt growth. (When prices subsequently decline they make these debts unsustainable - this is why house-price bubbles are usually more devastating than stock-market bubbles.)

So, Macro Maestro believes central banks are right to hold off policy tightening for now. At least until the main downside risks have gone. Sure, growth has only slowed in line with many economists' forecasts earlier in the year but we should wait till we can be sure there is nothing sinister behind this slowdown..

German deficiency

Macro maestro is finding it hard to get excited about today's German GDP release. Sure, 2.2% growth on the quarter is impressive but once again it is likely global demand is driving this rather than anything domestically generated. While we don't have any details on the composition of German GDP, we can get a rough idea by looking at other data from Europe's largest economy.

In particular, while manufacturing orders have surged, strong demand for exports and domestic 'intermediate' goods largely explain this improvement (see chart). These intermediate goods are presumably being used to produce more exports. Crucially, consumer orders remain depressed and have barely recovered from their recession lows.

Repeating the pattern of the last decade, this weakness in German consumption shouldn't be suprising. As in 2005-2008, German consumers are feeling more optimistic (consumer confidence has jumped higher) but are reluctant/unable to spend. A quick glance at wages explains why - after a modest recovery in 2007 as the labour market tightened and German unions became more militant - pay growth promptly returned to its usual depressed levels.

So where does this leave us? Again the situation in Germany is dependent on developments elsewhere - the economy remains geared to the global growth cycle. If global demand contines to grow, German activity might eventually become more balanced. The labour market should continue to impove, so wage growth might rise and the German consumers will probably start to spend. There is also pent up demand for investment. But if the global economy starts to low - and recent indicators in the US and China suggest this has already started - Germany will surely follow.

Those hoping Germany can help sustain global demand look sadly deluded. (Macro Maestro was once one of them but generally tries to learn from his mistakes..)

Japanned

In early 2008, as global stock markets hit their lows and many of the world's banks seemed on the brink of outright collapse, Macro maestro was reading a lot of comparisons between the US/UK economies and Japan. He was told the Anglo-Saxon economies now faced a similar 'lost decade' of growth. At the time, this analysis didn't seem right. Sure there were similarities - huge private-sector debts, rapidly falling asset prices, zombie banks - but there were also important differences.

Above all, the Federal Reserve and Bank of England seemed to have learned the lessons of the Japanese experience. Rather than wait for their economies to enter recession, they cut interest rates rapidly in anticipation of that weakness. Then, when there was no more space to cut interest rates, they moved to quantitative easing (QE) - adding further monetary stimulus by effectively printing money. It took the Bank of Japan almost a decade to try quantitative easing, the Bank of England tried it within 18 months of the crisis hitting their economy.

By the end of 2009, it seemed QE was having the desired effects. While the money supply and bank lending remained weak, asset prices were growing strongly. Stock markets had surged, credit conditions had improved and in the UK, even house prices had confounded expectations and started to rise again. The world's central banks seemed to have convinced markets that 1) they would do whatever it took to restore growth and 2) there were new monetary policy options available even at the zero bound (zero nominal interest rates).

But once again things are starting to look decidedly shaky. Growth has returned, but it is uneven and fragile. Bank lending and money supply remains weak. The US housing market is yet to see any genuine improvement and the UK market seems to be turning down. To some extent, this loss of momentum was inevitable. The effects of past monetary stimulus must eventually start to fade. For example, cutting interest rates boosts disposable income growth for a while but then as rates stabilize the effects on additional growth diminishes. Still, the problems seems to go deeper than that.

In response, the Fed and the BoE seem to be hinting at another round of QE. But will this be effective? The main benefit of QE last time was that is stabilized desperate private-sector sentiment and reassured financial markets. But if the first wave of QE failed to encourage a genuine self-sustaining economic recovery, it seems likely the private sector will be more skeptical this time. Indeed, additional QE might actually undermine confidence rather than restore it. ("Are policymakers really that desperate? Damn, things must be worse than I thought!") And that, of course, leaves us in a genuine nasty position. Bond markets seem to have imposed a limit on fiscal consolidation, at least in Europe. While monetary policy seems to have run out of effective options. Suddenly, those comparisons with Japan don't seem so misguided...