We live in fascinating times – largely thanks to the QE revolution.
When two of the most important data seen in the last two years are screaming that the Fed is going to start hiking soon, and you see LT and ST rates going DOWN, because that is pushing equities DOWN… you know there is a big problem going on. That is particularly true when the Fed is telling you that the Conundrum 2 is becoming one of their big worry…
The Fed has been saying for months that it expected wage inflation to appear, to start the hiking cycle. Last month we had the rise in the ECI… nobody cared. Last Friday we had the rise in average earnings… US equities started falling. Interestingly according to the financial press – and confirmed by market internals it was mostly due to the energy sector finally going down. The Greece Damocles threat didn’t help either.
Now we have the inflation expectations of the Michigan survey – one of the best inflation survey available – showing that despite collapsing gaz prices, inflation expectations are going UP. If the Fed isn’t happy with that… what does it need?
And… finally… we are seeing some reactions from equities. As I discussed at length in a recent post – most believe wrongly – based on historical (and inappropriate) basis that the start of a rate hike cycle is bullish equities. True historically, except that this time the Fed has been deliberately using equities for 5 years to help in the deleveraging process. And that the process is over, they said explicitly many times that now they didn’t care anymore about equity valuations.
Worse, Dudley had a great speech last week explaining that what would matter in the speed and size of the normalization process was not the ST rates but how financial conditions would respond– and LT yields in particular. And he implied that the “Alan Greenspan conundrum scenario” was one of the big current worries at the Fed (inability of 10Y yields to rise in 2003/2007 despite a full cycle of ST hikes). He implied that the least the 10Y would react the more hikes were likely… (my take). [Find the full quote below…]
So of course the equity market reaction and the break in correlations that we are seeing might be due solely to end of week / end of year profit taking or may be just oil related. Maybe the last trend of the year will be a big squeeze (of USD longs, and equities)… maybe not. Maybe it will be next year. Who knows?
But in any case, we now know that 1/ we now have the data that the Fed has hoped to see for 3 years, 2/ we have an equity response that is highly worrying because it goes against the dominant assumption that equities will rise on the start of the rate hike cycle (as it historically does), 3/ finally, and quite worryingly we have a Fed that is worried about a conundrum 2 scenario that would necessitate more or faster tightening.
So staying too long in crowded markets might definitely be a bad idea. Tactically, on the contrary going for the squeeze makes a lot of sense. It actually reminds me of the taper tantrum in Q2 2013.
With respect to “how fast” the normalization process will proceed, that depends on two factors—how the economy evolves, and how financial market conditions respond to movements in the federal funds rate target. Financial market conditions mainly include, but are not necessarily limited to, the level of short- and long-term interest rates, credit spreads and availability, equity prices and the foreign exchange value of the dollar. When the FOMC adjusts its short-term federal funds rate target, this does not directly influence the economy since little economic activity is linked to the federal funds rate. Instead, monetary policy affects the economy as the current change in short-term interest rates and expectations about future monetary policy changes influence financial market conditions more broadly.
Developments in financial market conditions are thus an important element in the transmission mechanism of monetary policy to the economy. Changes in financial market conditions influence economic growth through a number of channels. For example, a stronger equity market raises household wealth and lowers the desired personal saving rate—lifting consumer spending. A stronger equity market also reduces the cost of capital for business, which may help encourage greater investment spending. Lower long-term interest rates push down business financing costs, which also supports investment spending. At the same time, lower mortgage rates support housing demand and reduce household interest outlays. A weaker dollar supports growth by making imports more expensive and by increasing export competitiveness. The combined effect is to increase net exports.
If the linkage from the federal funds rate to financial market conditions were stable over time, there would be no need to focus on financial market conditions. In a world in which the linkage was solid and unchanging, adjustments to the short-term interest rate and communication about future policy would have a predictable and reliable effect on financial market conditions. Central bankers, then, could keep their focus narrowly on their policy rate.
However, as has been very clear, especially in recent years, this linkage is not stable. Thus, how much one pushes on the short-term interest rate lever depends, in part, on how financial market conditions respond to such adjustments. Imagine driving a car where the connection between the gas pedal and the engine speed was variable and uncertain. The driver would have to constantly monitor and adjust the pressure on the gas pedal to achieve the desired speed. Similarly, we will have to monitor and adjust short-term interest rates to achieve financial market conditions consistent with achieving our labor market and inflation objectives. All else equal, less responsiveness implies larger interest rate adjustments and vice versa.
Quickly, let me give two examples that illustrate how variable this linkage can be. First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened. As a result, financial market conditions did not tighten.
As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.
Economics 101 – What should a central bank (the Chinese PBOC) do when:
1/ its currency has appreciated by 30% in REER terms over the last 5 years,
2/ it has a semi-peg with a currency (USD) whose central bank is about to embark on a rate hike cycle,
3/ the government has been implementing ambitious and far reaching structural reforms to the point that the two main engines of growth are slowing fast, and only external demand is helping somewhat,
4/ inflation is collapsing because of an oil shock and a sharp drop in food inflation, and also because of excess capacities,
5/ one of his major trade partner and competitor (Japan) has just devalued its currency by 40% (without one inch of structural reforms) and all regional currencies are starting to react to that,
6/ its economy is slowing down fast but its policy makers don’t want to send the wrong message with rate cuts because it is dealing with a credit bubble (see the economist’s article this week),
7/ it has just chaired a major regional event where it showed its power and generosity… (and therefore, the calendar is now appropriate to refocus on its domestic agenda)…?
My guess is that a weaker Chinese currency would help…
Given the above, a subsidiary question is what should an investor do when :
1/ You can’t find a bank who doesn’t expect the USDJPY to reach 140 and the CNY to continue to rise indefinitely,
2/ the US treasury secretary just complained about BOJ QQE2, when not accompanied by structural reforms,…?
Well I would say that buying the USD/CNH doesn’t seem too risky to say the least (given the possible reward), AND that for JPY shorts and nikkei investors, I would watch the 6.1350 level of USD/CNH quite finely… because if it breaks it should be a sign of temporary FX policy shift in China… and that would change the context for Japan…
For readers who don’t remember well the asian crisis, here is an interesting text from the NY Fed WP. We are in a different situation today of course (NJA ccy are not pegged and have large reserves), but it is interesting to see how history sometimes rhymes…
What was the role of Japan, the leading regional economy, in the crisis? At the beginning of 1996 it appeared that the economy was recovering after five years of near zero growth, but with the increase in the consumption tax in April 1997 Japan fell into another economic recession: the level of activity actually declined in the second and third quarters. Clearly, the economic weakness in Japan contributed to the crisis in terms of a reduced demand for imports from the region. As Japanese authorities kept monetary policy loose and interest rates extremely low, the continued depreciation of the yen relative to the US dollar since the middle of the 1995 exacerbated the exchange rate tensions in the region, and in 1997 caused a steep real appreciation of the Asian currencies that were pegged to the dollar. The crisis finally exploded in the summer, when the dollar went through what seemed an unstoppable rise and the yen continued its decline.
The intellectual and political split in the French socialist’s party could be a major turning point for the buildup of a more fiscally integrated Europe, and would then significantly reduce the Euro’s structural weaknesses. Indeed, to me, the lack of intellectual reform within the French socialist party has been one of the main impediments to an adaptation of the very costly and inefficient French welfare state and thus to any fiscal integration / alignment with Germany.
NB – This is a post about the long term drivers of the Euro. In the short term the ECB is the key driver and my guess is that it will do its best to talk the EUR down to 1.20 simply because it is its best available tool (after a possible rebound as Draghi might disappoint very ambitious markets expectations at September’s meeting).
To introduce what we are talking about, I’ll remind Milton Friedman prophetic statements made in 2000 (I don’t want to elaborate on those structural issues which are well known): “I think that the euro is one of the few really new things we’ve had in the world in recent years. Never in history, to my knowledge, has there been a similar case in which you have a single central bank controlling politically independent countries. […] I think the euro is in its honeymoon phase. I hope it succeeds, but I have very low expectations for it. I think that differences are going to accumulate among the various countries and that non-synchronous shocks are going to affect them. On purely theoretical grounds, it’s hard to believe that it’s going to be a stable system for a long time. On the other hand, new things happen and new developments arise. […] You know, the various countries in the euro are not a natural currency trading group. They are not a currency area. There is very little mobility of people among the countries. They have extensive controls and regulations and rules, and so they need some kind of an adjustment mechanism to adjust to asynchronous shocks—and the floating exchange rate gave them one. They have no mechanism now. […] So the verdict isn’t in on the euro. It’s only a year old. Give it time to develop its troubles.”
The bottom line is that fiscal transfers of some sort, and ideally fiscal integration, are key to the Euro’s long term survival. Actually Draghi confirmed this view in his conclusion (that looked a lot like a warning to European governments) at Jackson Hole – “We should not forget that the stakes for our monetary union are high. It is not unusual to have regional disparities in unemployment within countries, but the euro area is not a formal political union and hence does not have permanent mechanisms to share risk, namely through fiscal transfers. Cross-country migration flows are relatively small and are unlikely to ever become a key driver of labour market adjustment after large shocks.”
The BIG problem until now was that it is politically difficult if not suicidal (for Germany) to fiscally integrate two countries that have so different welfare systems. In particular on the labor market, when one looks at the rules adopted in Germany with the Hartz IV reforms ten years ago and compare them to the unemployment rules in France, the difference is striking. The chart below from the IMF art 4, shows that France unemployment system is amongst the most generous in Europe for activation and in terms of amounts.
To give some more lively illustration, in France as long as you work 5 months, you can have 5 months of benefits, where you earn about 80% of your net salary. You can get benefits of up to 2 years. Until recently you could have the benefits even if you had resigned. You can still get the benefits if you decide to “abandon” your job (you just don’t show up). That’s great… but costly. Moreover, you don’t need to show up to get the benefits (only once a year), and actually just have to confirm through internet that you are still looking for a job. That’ why when backpacking around the world, you can meet many young French people who quite rationally work 6 months, then go on the dole for 6 months and travel (at least that was the case 12 years ago when I was travelling through Asia – I am getting older). Qui est fou? Of course contrary to Germany the income of your wife/husband, or your total wealth isn’t taken into account.
Or let’s talk about social housing (the famous HLM)… Paris city has been buying some of the nicest buildings to turn them into social housing where rents are about 10% of the market price. Look at this brand new complex (image below) just 150m from the Arc de Triomphe – avenue de Friedland – that is one of the great achievements of the Mayor, or La samaritaine of the nicest building in Paris. It is socialist Utopia! Free money for everyone – thanks Germany… And the best thing with Social Housing in France is that it is for life! If you get a 150sq m flat because you have 4 children, and 20 years later your kids leave elsewhere, you can be forced to leave only if you voluntarily declare that your situation has changed (same if you inherit). You bet that few are voluntarily asking to be relocated to a smaller place.
You have to live in France to believe it! Honestly no one in France can blame a German for not accepting to “subsidize” the generous French system.
So the bigger question is why do we have this situation in France, where the Socialist party has failed to reform intellectually contrary to the German SPD in 2004 or the new labor in the UK? Simply because France has benefited from the low German yields, from Draghi’s “whatever it takes” speech, and mostly because the Socialists were the main opposition party until 2012. So of course they didn’t have any incentive – in a period of crisis, and being in the opposition – to reform internally and open a debate about rules of good management and smart changes – but highly unpopular – to be made to the French welfare state. (I remember that already in 1996 Dominique Strauss Khan in his economic classes at the University was teaching that the French Pension system was doomed… Since then, nothing has changed, and I never heard a Socialist policy maker acknowledge the problem). Of course, as I explained in an earlier post – the general lack of understanding about economics in France also helped greatly. It helps many politicians like Arnaud de Montbourg or Marine le Pen propose economic policies completely ridiculous and outdated. And journalists never challenge policy makers on their economic policies (let’s not talk about the scandalous proximity between journalists and the political class). Even last Sunday in the great interview of E. Valls on France 2 TV, he talked about the Hartz IV reforms, but the journalist didn’t even think about asking him if that was something necessary / possible in France. The economic / cost debate has simply been inexistent for too long.
But, after two years in power, the Socialists had to choose because of the political and economic crises. Robert Feldman at MSDW had a model for Japan called CRIC, – crisis, response, improvement, complacency. It works a bit the same in France. At least a crisis is always a pre-condition to go through reforms. It reminds me in a sense of the “tournant de la rigueur” by Francois Mitterand in 1983. After putting the socialist official program in place, and the economic collapse that followed, he made a 180° policy turn. Over the last two years, France has had a major political crisis (with the Front National results), and is also dangerously close from a permanent economic crisis. The efforts made on the fiscal side have exclusively been made on the tax sides, and no spending cuts at all have been made. But Francois Hollande once called a Master of Ambiguity is now forced to make a choice (or rather let his intimate conviction be known).
The key question is to what extent a new true / honest / high level economic debate is going to appear within the Socialist party, and how it is going to “educate” french voters. De Montbourg is surely going to continue to criticize the government, and so they will have to reply. Of course it remains a socialist government and it would be highly surprising to see the equivalent of Hartz IV in France. But for sure the level of understanding of economic issues is going to improve greatly. THE DEBATE MIGHT FINALLY START. The idea within the French left that public money is free and without limit is going to be challenged. Some necessary reforms of the welfare state are going to be discussed (if it is to be saved) and benefit costs are finally going to be a parameter.
The whole process might end up with a new socialist party intellectually reformed, closer to the European social democrats. And that is a pre-condition for more fiscal integration at the European level. At least that’s a possible scenario, and the interview made in Le Point by the new economic minister Macron – who even dares proposing a reform of the 35 hours rule – is encouraging.
A final point, I have an immense respect for Krugman, Wolf etc… And I agree with them that austerity is a crazy policy in the midst of a demand crisis. And Germany (not France) should definitely have a stimulative policy. But I think one has to consider the problem from a political standpoint in Germany, not just from an economic one… That is unless you offer to the German taxpayers access to the HLM on avenue de Friedland…
Again, that’ a structural issue, not a market call to buy the EURO now…
It is Fed time again! Given the importance of the Fed factor as the primary market driver, Yellen’s speech on Friday will determine the investment strategy to be chosen in the coming quarter(s). Depending on her message, we will know whether we have to (continue to) build portfolios that are focusing on RV strategies (domestic factors) thanks to continued de-correlation and low volatility, or instead on global directional strategies (shifting Fed outlook) as investors’ long held assumptions are challenged, triggering volatility and correlation amongst assets.
In that respect, it is important to distinguish two levels of analysis in her speech – theoretical and tactical:
We know she will be dovish to answer to the “theoretical” debates within policy circles:
She will say what she already said. She will detail how she thinks we should be looking at the labor market beyond the simplistic unemployment rate. She will also confirm the idea that she faces an asymmetric risk, in the sense that we know how to deal with inflation but not with deflation. She will also confirm what Stanley Fisher has said with great talent and clarity two weeks ago. His speech is a must read (I have put the key parts at the end of this post), particularly for his analysis of the supply side, and his views on macro-prudential measures to deal with bubbles. Basically he has two big messages: 1/ there are plenty of good temporary reasons to explain the current weakness in both demand and supply, so it is most likely that the output gap is still large and that stimulating demand will succeed in raising employment participation… in other words there are no reasons to hike early ; 2/ bubbles have to be dealt with, and can be dealt with effectively thanks to macro-prudential measures – it is not the job of monetary policy which “deviates” from its goals if it takes them into account.
He made this speech to give his view on the two major theoretical economic debates that have been heating up all summer within policy circles. [Note that I call these debates “theoretical” because it is really about economic theory, but they are absolutely key in practical terms to choose the right exit path, so are highly relevant in policy terms.] There has been a debate on the size of the output gap, which basically means measuring the potential growth (supply side issues), so means having detailed analysis of the labor market and productivity. And there was another debate on the financial asset bubbles and how they should be dealt with. These debates started within the FOMC, with the usual hawks, but the BIS got into it in its annual report. Martin Wolf, Krugman, Pimco… all got into them. And it makes sense as they are key to frame the right monetary policy. And even if most are (rightly I think) criticizing the BIS policy recommendations (austerity), the work on the financial cycle and deleveraging are great (look at this chart of both cycles – isn’t it awesome?).
So in a sense the market is probably right to be expecting a dovish message because Yellen will answer to the economic debates that have been going on for several months, and will confirm what she said before.
But… beyond her answer on the “theoretical” debates, she might have another message for investors…
At the same time, Yellen has been very clear that she is finally going to raise rates and she knows she has to prepare the market for this transition (in other words forget QE infinity). The only way to do that is to opportunistically inject some risk premium into the market. And indeed, in tactical terms last year, it was rather clear that at every FOMC when yields were at their lows and equities at their highs (just like now) she made hawkish speeches (same for Bernanke), while on the contrary she was trying to quieten things only when LT yields were rising strongly.
More generally, what equity investors seem to miss is that equity markets have been used willingly by the Fed as a tool to facilitate the deleveraging process over the last 5 years. Bernanke actually acknowledged it in a Q&A session last year, when asked about equity valuations (by a Senator?) he replied that he was using the tools he had at his disposal. And now that growth is turning self-sustaining, and that the deleveraging process is complete (see the two graphs at the end), the Fed just doesn’t care anymore about equities. The main things that matter are yields (which are essential for the housing market), and the dollar maybe. That is why I find GS recent analysis on the historical behavior of equity markets following a first rate hike (a 6% annual rise during 3 years) particularly weird (unless they are just unwinding their positions). [Actually for those interested in the issue – historically it is not the first Fed rate hike that corresponds to a peak in equities, it is the bottoming of the 2Y10Y curve… see my ugly chart below – anyway that’s irrelevant in the current context]. So saying that equities are going to rise following the first rate hike – based on historical patterns… is just irrelevant – when you have 1/ a central bank that is embarked into a policy experimentation without historical precedent, and 2/ when this central bank has used equity markets has a quasi-policy tool. In other words, I disagree, and tend to think that markets are more likely to correct when the Fed switches to a new stance because of stronger growth. But as often, that might not be immediate.
One key indicator to see whether and when we are switching to a new equilibrium is the volatility of the US money market curve. If this vol increases (and it can only increase if Yellen wants it to increase or if she lets the policy debate becomes more open) then financial asset prices are likely to move to a new equilibrium (see chart – borrowed from macro-man – in one of his excellent posts). Yellen actually talked about that a few months ago (sorry I couldn’t find the speech yet). From what I remember she distinguished between two things – that the market doesn’t take properly into account – one is the central forecast of keeping rates low, the other is the risks (or volatility) around these forecasts. It is precisely on that second part that she could elaborate.
All that to say, that if Yellen allows the markets to go straight on into a new phase of risk taking, when all assets are already close to their record highs (equities, but also EM assets, and everything else) and when LT yields and volatility are at their lows, it seems to me that it would be a tactical policy mistake. And that would surprise me.
Maybe of course, she’ll choose another timing, and will be both theoretically dovish and tactically dovish tomorrow. Then we will have to wait later that she decides to inject some volatility into the money market curve (Q4?, H1 2015?). If so, that will only bring bigger correction moves when they come… And in the meantime – at least for Q3 – we will know that we have to focus on RV macro trades.
So in terms of investment conclusions, that means that 1/ given current levels on the SPX and the EDZ4Z5, at minima exposure should be reduced / partial profits taken, 2/ we will know only after the speech what trading strategies should be emphasized for H2 – whether we have to trade RV (selective long EM?) or Global directional for Q3.
A few extras…
On Household Deleveraging
From MPR pg 10
Reflecting those solid gains, aggregate household net wealth is estimated to have approached 6½ times the value of disposable personal income in the first quarter of this year, the highest level observed for that ratio since 2007 (figure 16).
Coupled with low interest rates, the rise in incomes has enabled many households to reduce their debt payment burdens. The household debt service ratio—that is, the ratio of required principal and interest payments on outstanding household debt to disposable personal income—dropped further in the first quarter of this year and stood at a very low level by historical standards (figure 17).
Two key parts of Stan Fisher important speech
(bold parts are from me.. :-) (for some reasons underlining and coloring don’t work today on WordPress…)
This pattern of disappointment and downward revision sets up the first, and the basic, challenge on the list of issues policymakers face in moving ahead: restoring growth, if that is possible. In some respects, we should not have been surprised at the prolonged hit to output growth following the global financial crisis. As Cerra and Saxena and Reinhart and Rogoff, among others, have documented, it takes a long time for output in the wake of banking and financial crises to return to pre-crisis levels.5 Possibly we are simply seeing a prolonged Reinhart-Rogoff cyclical episode, typical of the aftermath of deep financial crises, and compounded by other temporary headwinds. But it is also possible that the underperformance reflects a more structural, longer-term, shift in the global economy, with less growth in underlying supply factors.
Separating out the cyclical from the structural, the temporary from the permanent, impacts of the Great Recession and its aftermath on the macroeconomy is necessary to assessing and calibrating appropriate policies going forward. The difficulty in disentangling demand and supply factors makes the job of the monetary policymaker especially hard since it complicates the assessment of the amount of slack, or underutilized productive capacity, in the economy. Over the longer term it will be possible to disentangle the amount of slack on the basis of the behavior of prices and wages as the levels of resource utilization in economies rise, but it would be better to understand why growth has been so slow without experiencing either a runup in inflation or a descent into deflation.
In the United States, three major aggregate demand headwinds appear to have kept a more vigorous recovery from taking hold. The unusual weakness of the housing sector during the recovery period, the significant drag–now waning–from fiscal policy, and the negative impact from the growth slowdown abroad–particularly in Europe–are all prominent factors that have constrained the pace of economic activity.
The housing sector was at the epicenter of the U.S. financial crisis and recession and it continues to weigh on the recovery. After previous recessions, vigorous rebounds in housing activity have typically helped spur recoveries. In this episode, however, residential construction was held back by a large inventory of foreclosed and distressed properties and by tight credit conditions for construction loans and mortgages. Moreover, the wealth effect from the decline in housing prices, as well as the inability of many underwater households to take advantage of low interest rates to refinance their mortgages, may have reduced household demand for non-housing goods and services. Indeed, some researchers have argued that the failure to deal decisively with the housing problem seriously prolonged and deepened the crisis.6 Growth in other countries that experienced financial crises, including the United Kingdom, Ireland, and Spain, has been weighted down by struggling residential sectors. More recently, many of these factors have abated in the United States and yet, after encouraging signs of improvement in 2012 and in early 2013, over the past year the growth of residential construction has faltered and home sales have fallen off. The sharp rise in mortgage interest rates in mid-2013 likely contributed to this setback.
The stance of U.S. fiscal policy in recent years constituted a significant drag on growth as the large budget deficit was reduced. Historically, fiscal policy has been a support during both recessions and recoveries. In part, this reflects the operation of automatic stabilizers, such as declines in tax revenues and increases in unemployment benefits, that tend to accompany a downturn in activity. In addition, discretionary fiscal policy actions typically boost growth in the years just after a recession. In the U.S., as well as in other countries–especially in Europe–fiscal policy was typically expansionary during the recent recession and early in the recovery, but discretionary fiscal policy shifted relatively fast from expansionary to contractionary as the recovery progressed. In the United States, at the federal level, the end of the payroll tax cut, the sequestration, the squeeze on discretionary spending from budget caps, and the declines in defense spending have all curtailed economic growth. Last year, for example, the Congressional Budget Office estimated that fiscal headwinds slowed the pace of real GDP growth in 2013 by about 1-1/2 percentage points relative to what it would have been otherwise. Moreover, state and local governments, facing balanced budget requirements, have responded to the large and sustained decline in their revenues owing to the deep recession and slow recovery by reducing their purchases of real goods and services. Job cuts at federal, state, and local governments have reduced payrolls by almost 3/4 of a million workers, resulting in a decline in total government civilian employment of 3-1/4 percent since its peak in early 2009.7 The fiscal adjustments of the last few years have reduced the federal government deficit to an expected level of 3 percent of GDP in 2014 and fiscal drag over the next few years is likely to be relatively low.
A third headwind slowing the U.S. recovery has been unexpectedly slow global growth, which reduced export demand. Over the past several years, a number of our key trading partners have suffered negative shocks. Some have been relatively short lived, including the collapse in Japanese growth following the tragic earthquake in 2011. Others look to be more structural, such as the stepdown in Chinese growth compared to its double digit pre-crisis pace. Most salient, not least for Sweden, has been the impact of the fiscal and financial situation in the euro area over the past few years. Weaker economic conditions in Europe and other parts of the world have weighed on U.S. exports and corporate earnings; added to the risks that U.S. financial institutions, businesses, and households considered when making lending and investment decisions; and at times depressed U.S. equity prices.
The housing market, fiscal consolidation, and unexpectedly anemic foreign demand all play a significant role in explaining the weakness of aggregate demand in the U.S. economy, weakness that could not have been accurately predicted based on past recession experiences or by the fact that this recession started with a massive financial crisis.
But, turning to the aggregate supply side, we are also seeing important signs of a slowdown of growth in the productive capacity of the economy–in the growth in labor supply, capital investment, and productivity. This may well reflect factors related to or predating the recession that are also holding down growth.
How much of this weakness on the supply side will turn out to be structural–perhaps contributing to a secular slowdown–and how much is temporary but longer-than-usual-lasting remains a crucial and open question.
Looking at the aggregate production function, we begin with labor supply. The considerable slowdown in the growth rate of labor supply observed over the past decade is a source of concern for the prospects of U.S. output growth. There has been a steady decrease in the labor force participation rate since 2000. Although this reduction in labor supply largely reflects demographic factors–such as the aging of the population–participation has fallen more than many observers expected and the interpretation of these movements remains subject to considerable uncertainty. For instance, there are good reasons to believe that some of the surprising weakness in labor force participation reflects still poor cyclical conditions. Many of those who dropped out of the labor force may be discouraged workers. Further strengthening of the economy will likely pull some of these workers back into the labor market, although skills and networks may have depreciated some over the past years.
Another factor that may be contributing to a slowdown in longer-run output growth is a decline in the rate of investment. As is typical in a downturn, movements in investment were important to the cyclical swings in the economy during the Great Recession. And, as would be expected given the depth of the downturn, investment declines were especially large in this episode. However, in the United States, and in many other countries as well, the growth rate of the capital stock has yet to bounce back appreciably–despite historically low interest rates, access to borrowing for most firms, and ample profits and cash–causing concerns over the long-run prospects for the recovery of investment.
Turning next to productivity growth, Solow’s famous result over fifty years ago was that over eighty percent of growth in output per hour in the period 1909-1949 came from technical change.8 Between 1964 and 2003 total factor productivity growth in the United States averaged around 1-1/2 percent, contributing to a 2percent expansion per year in U.S. GDP per capita. At this rate, American standards of living would double every 35 years.
However, productivity growth in recent years has been disappointing. Over the past decade, U.S. total factor productivity growth declined to 1 percent, which some argue may represent the real norm for the U.S. economy.9 In this view, the long period of rapid productivity growth spurred by the technological innovations of the first and second Industrial Revolutions ended in the 1970s and the economy has continued at a lower productivity growth rate since then, except for a brief burst in the mid-1990s. In particular, these authors argue that the information technology (IT) revolution of the past several decades–including the diffusion of computers, the development of the internet, and improvements in telecommunications—was an anomaly and is unlikely to generate the productivity gains prompted by earlier innovations such as electrification and mass production.
Obviously, future productivity growth in the United States and in the world is yet to be determined. Possibly we are moving into a period of slower productivity growth–but I for one continue to be amazed at the potential for improving the quality of the lives of most people in the world that the IT explosion has already revealed. Possibly, productivity could continue to rise in line with its long-term historical average.10 After all, as the experience of the 1990s shows, productivity cycles are extremely difficult to predict and, even considering the slowdown of the past decade, U.S. total factor productivity growth fluctuated around 1-1/2 percent in the postwar period. In addition, the recent weakness could reflect Reinhart-Rogoff cyclical factors associated with the financial crisis, and pent up improvements could be revealed once confidence returns.11 Finally, fears about the end of productivity gains are based on evidence from the United States and other advanced economies. Globally, however, there is tremendous scope for productivity gains reflecting technological catch up, infrastructure investment, and the potential for human capital increases due to improvements in education and nutrition, and the incorporation and inclusion of women into the labor force. These gains should benefit not just the emerging market economies but also the rest of world more generally, including the United States.
At the end of the day, it remains difficult to disentangle the cyclical from the structural slowdowns in labor force, investment, and productivity. Adding to this uncertainty, as research done at the Fed and elsewhere highlights, the distinction between cyclical and structural is not always clear cut and there are real risks that cyclical slumps can become structural; it may also be possible to reverse or prevent declines from becoming permanent through expansive macroeconomic policies.12 But three things are for sure: first, the rate of growth of productivity is critical to the growth of output per capita; second, the rate of growth of productivity at the frontiers of knowledge is especially difficult to predict; and third, it is unwise to underestimate human ingenuity.
What can the central bank do when financial stability is threatened? If it has effective macroprudential tools at its disposal, it can deploy those. If it does not itself have the authority to use such tools, it can try to persuade those who do have the tools to use them. If no such tools are available in the economy, the central bank may have to consider whether to use monetary policy–that is, the interest rate–to deal with the threat of financial instability. At the moment in the U.S., though there may be some areas of concern, I do not think that financial stability concerns warrant deviating from our traditional focus on inflation and employment.
A decision on whether to use the interest rate to deal with the threat of financial instability is always likely to be difficult–particularly in a small open economy, where raising the interest rate is likely to produce an unwanted exchange rate appreciation. So a critical question must be whether effective macroprudential policies are to be found in the country in question.
I had some experience with these issues while at the Bank of Israel. In Israel, three separate regulators deal with different aspects of macroprudential policy, but there is no formal financial stability committee. The Bank of Israel is also the supervisor of banks, so has considerable power over housing finance, which essentially is available only from the banks. Starting in 2010, the Bank of Israel adopted several macroprudential measures to address rapidly rising house prices, including higher capital requirements and provisioning against mortgages; limits to the share of any housing financing package indexed to the short-term (central bank) interest rate to one-third of the total loan, with the remainder of the package having to be linked to either the five-year real or five-year nominal interest rate; and, on different occasions, limits to the loan-to-value (LTV) and payment-to-income (PTI) ratios. Additional precautionary measures were also implemented in the supervision of banks.
The success of these policies was mixed. The limit of one-third on the share of any housing loan indexed to the short rate substantially raised the cost of housing finance and was the most successful of the measures. Increases in both the LTV and PTI ratios were moderately successful. Increasing capital charges and risk weights appeared to have little impact in practice.
This experience led me to three conclusions on the effectiveness of macroprudential policies. First, we were very cautious in using these new tools because we did not have good estimates of their strength and effectiveness. Quite possibly, we should have acted more boldly on several occasions. Second, use of these tools is likely to be unpopular, for housing is a sensitive topic in almost every country. And third, coordination among different regulators and authorities can be complicated.
The difficulty of coordinating among different independent regulators makes it likely that the degree to which macroprudential policies can be successful depends critically on the institutional setup of financial supervision in each country. Different countries have structured their macroprudential policymaking institutions in different ways. In the U.K., the Financial Policy Committee has been set up within the Bank of England, with the power to make financial policy–including macroprudential policy–decisions. In the U.S., the Financial Stability Oversight Council is a coordinating committee of the major regulators. And in Sweden, responsibility for macroprudential oversight and financial stability lies with the Financial Supervisory Authority, which is separate from the Riksbank.
Overall, it is clear that we have much to learn about both the effectiveness of different macroprudential measures, and about the best structure of the regulatory system from the viewpoint of implementing strong and effective macroprudential supervision and regulation. And, while there may arise situations where monetary policy needs to be used to deal with potential financial instability, I believe that macroprudential policies will become an important complement to our traditional tools. Learning how best to employ all of our potential policy tools, and arrive at a new set of best practices for monetary policy, is one of the key challenges facing economic policymakers.
The drop in the copper market is obviously the direct consequence of the FX policy shift in China. The shift is creating unintended consequences due to financial linkages, and here it is one the most well-known part of some of the Chinese carry trades (copper collateral) that is unwinding quickly. It has no importance in itself, but as an early indicator of credit bubble burst and eventual contagion it is very important. So it definitely has to be seen in relation to the moves we have seen two weeks ago on the CNY-CNH and on the Chinese Ted Spread.
Of course one can argue – as all investors currently do – that 1/ the Chinese authorities have a good policy track record (I would moderate that because in a credit bubble, your policy is always good until the bubble bursts… anyone remembers the god like status of Alan Greenspan before 2008?), 2/ that the Chinese authorities have the financial resources to deal with the recapitalization of any financial institutions / trust / companies threatened so the shadow banking system is not such an issue, 3/ the real risk is real estate.
I agree, those points make sense, except that in all bubbles, there are some financial dimensions and interlinkages that are always misunderstood. And it is often when policy makers try to deal with these bubbles that they end up making mistakes as they disturb the unsteady balance that has been the source of massive position accumulation. Moreover the unsteady financial equilibrium that lasted for at least 5 years is now facing not one but three major changes. First the Fed is reducing its liquidity ceteris paribus (see Yellen below); Second China is slowing; and Third it is in the process of liberalizing its capital account and dealing with its shadow banking system. All three policy shifts involve major risks. [On the topic of LT implications of China’s capital accounts liberalization – read this excellent paper from the BoE].
The big unknown here of course is how much of the Chinese credit bubble and corporate carry trades have been affecting global markets? How many (EM?) financial institutions are involved? The general opinion is not much, and things are under control, at least on the financial side. But what do we know exactly? The BIS and the IMF recently wrote two excellent pieces explaining how EM corporates were involved in massive balance sheet carry trades through their subsidiaries, and creating FX exposure that were not apparent in external debt balance of payment reporting (see the 2 graphs below). What I find really instructive in these papers is that many financial mechanisms / behaviors are not reported properly in international statistics, so we can’t really assess the risks … In other words we know that we don’t know everything, and that every bubble creates some new financial mechanisms.
The situation in China is probably even more opaque given that companies have been doing their best to avoid capital controls for years.
Yellen explained clearly four years ago (I doubt she would repeat that today) how US monetary conditions were affecting China: “China restricts capital inflows and outflows. These restrictions provide considerable—but not complete—insulation from foreign monetary policies and give the People’s Bank of China scope to conduct independent monetary policy. However, investors find ways to evade China’s capital controls and are pouring in money to take advantage of higher interest rates, a booming stock market, and an apparent gamble with only upside risk on future renminbi appreciation”.
More recently the FT explained in details the Chinese Corp carry trade – borrowing in USD abroad (0.25%), converting to CNY and investing in Trust products (5 to 10%)… [Doesn’t it sound like Easy money and win win trades…?] So for sure Copper is another warning sign. It might stop there. But there might also be contagion. The FT reported recently that Hong Kong and Singapore banks were heavily involved. So investors should be very attentive to any other sign of side effects in the coming weeks. I guess the first two things to watch is whether Copper breaks the $300 level, and how Hong Kong and Singapore banks and equity markets will react. That would be important signs of contagion… (and the SPX is not priced for that).
When I think about China’s policy situation, I can’t help but think of the HuaShan path (a sacred Taoist mountain that I climbed a few years ago). It is going up, it is gorgeous, everything is great… but the path is very narrow and slippery, so you’d better not fall either side because it’s a free fall guaranteed… (see below).
In my last post I signaled the possible market confusion about the Fed’s dovishness. For sake of clarity, I voluntarily skipped an important development going on within the Fed’s policy framework – the switch from a focus on tapering bond purchases to a focus on thresholds of forward guidance.
Ahead of the Fed minutes tomorrow, this switch deserves some explanations for three reasons: 1/ it is probably the main reason why the market got confused about Fed’s dovishness; 2/ the market has started being sensitive to this switch as can be seen in the correlation break between the 2Y USD and the 10Y USD; 3/ the reliance on forward guidance involves some risks for the Fed as controlling indirectly money market expectations is very different from controlling directly the 10Y yields – as the BoE experience has shown recently.
1/ In Fedspeak, tapering is not tightening.
In virtually every newspaper last week you could read that Yellen had been dovish, the main reason being cited was that she said that the output gap was such that accommodative monetary conditions were necessary for a long time. Many concluded that tapering will be pushed back. But the Fed has been clear for a very long time that tapering – the end of bond purchases – would not affect monetary conditions. In other words, in Fedspeak, ending purchases will keep monetary conditions as accommodative as before. That will just stop them from becoming more accommodative. So when Yellen or Dudley yesterday, are saying that the size of the output gap, or low inflation should be met with accommodative conditions, it does not mean at all that tapering is going to be pushed back. That’s a key source of confusion I think.
2/ 2Y – 10Y correlation break indicates that the switch in tools has started.
That being said, when one looks at a chart of 2Y and 10Y USD yields (below), it is clear that the two maturities have been pricing something different (NB. I voluntarily take 2Y Swaps vs 10Y Govies to take what I consider to be a more accurate picture of Fed expectations vs Financing conditions in the Bond market). One can notice that since end October, the 2Y has fallen, while the 10Y was rising (red arrows in the upper panel). This is a rare occurrence, as the curve tends to bull flatten (lower yields , with the 10Y going faster down) or bear steepen (higher yields with the 2Y going faster up).
That has occurred because the Fed has two main policy tools – it’s bond purchases (QE) with which it impacts directly the 10Y yields, and the forward guidance and its thresholds (when will rate hikes start) with which it tries to impact the money market curve and also indirectly the long term rates (which are an aggregation of expectations of forward short term rates and a risk premium).
The thing is, because QE is seen as having high risks, tapering needs to take place. But because the Fed doesn’t want long term yields to spiral higher, it might be trying to “compensate” by being dovish in terms of forward guidance. That is why we are seeing a higher 10Y, and simultaneously a lower 2Y.s why the Fed message has seemed so confused. But actually, attempting to differentiate between these two tools is the very reason why forward guidance (see QE4) was created.
The divergence in yields was triggered by the debate on thresholds. At the start of the month, two major papers were published by the Fed research discussing the possibility of lowering the unemployment threshold or adding an inflation threshold, one by English and the other by Wilcox. I must confess I didn’t read them, but from discussions I had, I tend to think that it is more likely that the Fed would add an inflation threshold, rather than move the unemployment threshold (which would tend to be more risky in terms of credibility).
Another factor that has helped the divergence between 2Y and 10Y in that period was the drop in inflation. Inflation has surprised on the downside and even without a formal inflation threshold it has mechanically pushed back expectations about the first rate hikes.
In any case, around this time window, the high frequency correlation between the 2Y and 10Y (10 day, in return) moved from 80% to about 40%, showing clearly how the two Fed tools were affected by a different message. The thing is, since then, the correlation has resumed which can be a good thing as long as market expectations about economic growth remain in line with the Fed’s scenario.
3/ But there are risks in the switch.
First, if you accept that what primarily matters for the economy is the ability to control the level of the 10Y yield and the 30Y MBS, then it is rather obvious that it is a risky move because the “forward guidance” tool is much less accurate. With QE, the Fed was directly buying bonds, while with Forward Guidance it is going to affect the long term yields only indirectly through the money market part of the curve.
Second, if for some supply / demand reasons, bond holders don’t want to buy more bonds (I think of EM central banks in particular – China and Japan), bonds will selloff whatever happens to the 2Y. The advantage with QE was that the Fed could directly affect the supply / demand balance and prevent a selloff, something that can’t be done with forward guidance. In that sense, forward guidance can work (in terms of impact on the 10Y) only in a context of stability of the bond market’s suppy / demand.
Third, the BoE’s experience with forward guidance has been a complete fiasco so far. In the sense that the rate market has reacted in “black or white” to economic news, by that I mean that the 2Y and 10Y GBP didn’t suggest any differentiation between end of QE and start of rate hikes. All good data were pushing both yields higher (see chart). And the correlation between the two yields is at a high.
That makes sense in a way because at the end of the day forward guidance is data dependent, so what really matters are market expectations about the economy. The thresholds are a framework, but the actual Policy moves will depend on your economic forecasts! Worse in terms of precedent, the market was proven right in its economic forecasts and it is the BoE which last week modified its expectations of first rate hikes and moved them forward by 18 months! (ok admittedly the Fed has a better forecasting track record…).
Recently the Fed has had two messages for two different tools – QE and forward guidance. That might have been a source of confusion for some investors.
At the same time, the correlation break between the 2Y and the 10Y might prove transitory as it was driven by temporary factors: 1/ the current debate on integrating an inflation threshold or lowering the current unemployment threshold, and 2/ a downside surprise on inflation. Once these factors are over (priced in), better data might tend to push all yields higher once again just like in the UK, because in the end what matters are data and economic forecasts. If so, relying on forward guidance would mean more difficulty for the Fed to control the 10Y yield, putting the valuation of many financial assets at risks.
Tomorrow’s minutes are likely to be very instructive, watch the reaction of the 2Y-10Y!
Market’s misunderstanding about the Fed’s message has been a great trading edge over the last 5 months. With the market’s reaction to Yellen’s confirmation hearing, I wonder whether a new confusion – and trading opportunity – is not appearing. Indeed I see absolutely nothing new in terms of tapering odds and timing in her testimony, it is just pure policy continuity.
First, I want to apologize to my regular readers for not writing for quite a while… I am the happy father of a second child so sleepless nights have had a direct impact on my propensity to write. As I kept following markets astutely in that period, I will write a few stuffs in the coming weeks to catch up on what I think are the biggest developments. But for now, let’s discuss the global view and the biggest factor affecting it – the Fed’s tapering…
Coming back on the history of tapering:
In March already the debate about the timing of QE’s end started. At the time I wrote “the debate about the timing of QE ends should last. If that is the case, 10YUSD could rise further and break the 2% threshold for good, then it would affect all valuation metrics, in particular, it could have consequences for corporate bonds, EM bonds currencies and equities and DM equities”.
In May, Bernanke confirmed that the “exit” was coming, but the market thought –wrongly – that it was a communication mistake from the Fed. I thought at the time that “importantly, and contrary to many, I don’t think the Fed is surprised or scared by the market moves. I think it had exactly the reaction it hoped for. Delaying it too much would have been a mistake.”
Then, finally starting in July, Bernanke clearly suggested that the relative stability of the 10Y yield was a key pre-condition for tapering to take place, but again as I wrote at the time, nobody noticed. I noted that the Fed’s core assumption was that “thanks to the forward guidance and clear indication that there will not be any faster rate hikes, then 10Y yields should stay where they were initially”. [Admittedly, following discussions with my ex-colleague Olivier K, I oversimplified here; and should have written that the Fed expected only a limited rise – rather than no rise at all]. What is even more astounding is that I wrote that “Bernanke replied frankly as usual, and he said that indeed he and other members of the FOMC now had doubts about that core assumption, notably following the recent rise in yields (that was last month). Yes, it is amazing. And amusingly that went totally unnoticed and unreported (to my knowledge).”.
Recent swings in tapering expectations:
All that to say, that when after the summer, you could see the chart below, it was the single most important piece of data you could see. And there was zero doubt that the Fed would be much more dovish than what the market expected. Despite that, the market was very very surprised on September 18, showing how far the misunderstanding had run.
The chart clearly showed that the sharp unwanted rise in 30Y mortgage rates had triggered a collapse in refinancing, which would surely impact the most important pillar of the US economic recovery – that is the housing market. At that time there was a clear trading edge for investors as Fed’s dovishness / later tapering was highly likely. And indeed the Fed’s delayed tapering has been the key driver of the equity rally.
I must say that the most striking comment came from a Fed watcher I respect a lot at Pimco who wrote that he was surprised that the Fed had talked about “tightening of financial conditions” in the Sept communique, when stocks were at some record highs! Didn’t he realize that the 10Y yields and Mortgage yields were the two most important tools for the Fed?
Yellen’s confirmation hearing:
That brings me to another trading edge. I realized at the end of Bernanke’s conference on September 18 (when tapering was supposed to be announced – in other words, at the most important policy event of the last five years) that there were only 5000 people still logged onto the Fed web site to listen to his answers. When you compare that with the number of Bloomberg terminals (310 000?) you can easily understand how most investors don’t know much about the thought process of the most important policy maker on the planet. Most just take for granted what their average reporter / analyst has understood or heard from someone else.
And finally that brings me to Yellen’s speech. When you look at the market’s reaction to yesterday’s hearing, it is as if there were some new information, or even a policy turn. But Yellen has been key in the framing of most of what Bernanke has been doing for years now. I see nothing but continuity in her speech and in her answers. Why would anything she said yesterday indicate that tapering is going to be delayed further? For instance she is the main architect of the “forward guidance” as I exposed already last year. She also already gave her view – which is the Fed’s official view – on “search for yield behaviors” a long time ago. If anything, the only thing that I find interesting is a confirmation of the doubts that Bernanke signaled about the Fed’s core assumption (see above – the stock or flow debate). Indeed, according to the FT she confirmed that the recent rise in rates had caused the Fed to “ask ourselves whether or not that could potentially derail what we were trying to achieve”.
More important, it is sure that Bernanke and Yellen have been preparing for the transition for at least several months. Yellen certainly had an important role both in the decision to push back the tapering (as financial conditions had tightened too much), but also in the wording of the latest Fed communique which intentionally withdrew the reference to tighter financial conditions, signaling that Tapering could finally occur before year end – despite the fiscal cliff fight.
Where does this leaves us?
That leaves us simply where we were after the latest FOMC. Like the Fed we need to watch the data to have a view on Tapering’s timing. And data have not sent a clear and consistent message, so we are in transition…
On one side we have the latest Non-Farm Payrolls which have been very good, we have the last FOMC communique that got rid of the “financial condition” mention, and we have spreading global growth. On the other side, we have US cyclical data that have been marginally disappointing (ISM new orders down to 56.1 in Oct from a top of 60.5 in Aug; GDP growth showing weakening consumption and excessive inventory buildup, Conference Board Consumer confidence down to 71.2 from 79.7), and concerns on housing (pending home sales slowing down to 3 years low at +1.1% y/y from +2.9%y/y). Plus the effects of the Debt ceiling fight unclear (from a statistical and growth point of view).
The slight breakdown in price action between the Bond market and equities (in blue below) might be a confirmation of that transition thesis. Don’t get me wrong, if DATA end up supporting a tapering delay then I reckon that it would legitimate (from a macro standpoint) a continuation of the equity rally. And that would likely be signaled by a Tnote rally, to new highs, maybe 130 / 131 are the obvious targets. But for that we need first to see more evidence from the data.
To conclude, Yellen was probably very much involved in the last FOMC’s communique where the “tighter financial condition” mention was deliberately suppressed. So again, like the Fed, we are left watching DATA to decide on the timing of tapering. And data have not sent a clear and consistent message in the last few weeks. That means that there is no particular trading edge currently (from a macro / policy standpoint) in staying in the market’s current trends.
Of course one might argue that the traditional year-end trend is currently gathering momentum so this is not a time to get out. That’s a possibility, but one should be aware that the rally has lost one of its key macro drivers (contrary to the last two months), and consequently if data fail to disappoint, another “alleged surprise” by the Fed might end the party all of a sudden at the worst possible time in the year. A risk reward tactic suggests waiting for a clearer turn in data. In the meantime we and the Fed are in transition.