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.)