Month: March 2015

Central bankers and investors: the deluded leading the cynical and naïve

A selection of my recent observations in client notes, speeches and radio appearances, which have provoked sufficient reaction to merit a further airing.

Fed loses ‘patience’                

Watching Fed-watchers is becoming increasingly complicated: possibly even a new application for game theory. The main divide is between the cynics and the naïve but there are many sub-divisions of which here are four main ones:

  • Conspiracy cynics: who are convinced the FOMC has a common agenda with one or more others, including Wall Street, the Republicans, the Democrats, the Treasury (but not the Obama White House) and other central banks.
  • Incompetence cynics: who think the FOMC collectively is out of its depth
  • Selectively naïve: who mostly take literally what the FOMC publishes in Minutes and post-meeting Statements, while accepting individual members can end up out on a limb periodically or permanently.
  • Deluded naïve: who believe that the policies of either or both Messrs Greenspan and Bernanke are still in force and nothing will be done to derail the bull market in equities.

Full disclosure: I am in the ‘selectively naïve’ camp but also have some sympathy with those who sense that the FOMC has lost its self-belief since Dr Yellen took over. However, my main evidence is the latest comprehensive speech from Vice-Chairman Stanley Fischer on March 23rd. There is too much self-justification for my taste but after setting out the various debating points Mr Fischer leaves no doubt that he deems it time to move on from QE and ZIRP. Two of his remarks stood out:

Beginning the normalization of policy will be a significant step toward the restoration of the economy’s normal dynamics, allowing monetary policy to respond to shocks without recourse to unconventional tools.

An increase in the target federal funds range likely will be warranted before the end of the year.

Having been largely but not totally convinced that the Committee would drop the reference to patience in its Statement on March 18th I now believe that there will be at least two but not more than three ¼% rate hikes in 2015. Almost all the cynics and, by definition, the deluded dispute this view, of course, but for various and varying reasons and with an assortment of timelines. Some concede there may be only one token rise of ¼% while others expect QE 4 to be launched.

The most plausible counter-argument is that the surging dollar is already threatening both US exports and the overseas earnings of US corporations and the FOMC will want protectively to slow down the normalisation process that began in early 2014 with the taper. It is true that the Committee appears more aware than in the past of life outside the US but any concern about the dollar will be confined to the possible impact on jobs. Similarly, it is the full employment mandate and not the stock market that is making the FOMC so keen to raise interest rates gradually. It is very hard to see the FOMC getting involved in ‘currency wars’.

Of course, the FOMC has a second mandate on price stability and the strong dollar will helping to keep inflation well below the target of 2% per annum. Oil prices have caused the headline Personal Consumption Expenditures Prices Index (PCE) to tumble and even the core PCE (excluding food and energy) is well below 2%. The separately calculated CPI index produced a shock deflation reading in January and only just managed to recover to zero in February. Here is another excuse to hold off raising rates should the FOMC get cold feet before or after this week’s meeting.

Nevertheless, since the turn of the year equity investors, while remaining reluctant to miss out on any brief rallies, have increasingly been getting the FOMC’s normalisation message. Investors in US Treasuries have been prepared for much longer for higher rates but they too have got caught out by sudden panics in markets that are much less liquid than they used to be. Reactions to Wednesday’s FOMC Statement, participants economic estimates (not least the famous ‘dots’ forecasting future rate decisions) and Dr Yellen’s press conference are unlikely to be symmetrical and even the widely-expected dropping of ‘patience’ should result in equities and bonds falling back quite sharply and the dollar rallying further. However, any sign of a new reluctance to raise rates would have a much larger positive impact on both equities and bonds while profit-taking would hit the dollar hard. The only caveat is that so many bets will already be in place that the initial price movements in response to the FOMC Statement may appear perverse.

ECB out of control

The Fed may still call the ultimate shots but recent market movements show that the ECB has created a new order or rather disorder. Money from the US and Asia is flooding into European equities and bonds while European money is flooding out even faster to overseas equities and Eurobonds issued by non-Europeans, who swap the proceeds into other currencies. The once mighty Single Currency is now the main funding vehicle for the global carry trade and that is all FX speculators need to know as they push for parity with the dollar. How the Bundesbank must be seething with rage as the DAX soars by over 20% so far in 2015 as the punters believe that exports and earnings from overseas operations represent a new Klondike! The other big exporting economies, France and Italy are not far behind and openly exultant. Only last week-end Italy’s finance minister was congratulating the ECB on the euro’s slide. Credit analysis has been side-lined as yields on all sovereign bonds plunge to ever new record lows. All the troubled EMU peripheral members (except Greece) are now paying less than the UK on maturities up to ten years: only Portugal comes even close.

This surge in speculative activity has been unleashed by a bank that used to put stability above everything else and used to raise official interest rates even when it was not necessary to do so. Of course, inflation is not currently the main danger but the custodians of monetary correctness and EMU federal orthodoxy are surely underestimating the risk of a stock-market induced slump. Growth in the global economy is slowing and Europeans will not be able simply to grab a bigger share, especially as many other central banks have similar ambitions for their currencies. Moreover, Europe is very dependent on imports that are priced in dollars that will now cost a lot more, which may be good for headline CPI inflation but will push up factory output prices.

China Footnote on investor delusions

The casino known otherwise as the Shanghai Composite has risen by 5% since the publication of surprisingly plausible Industrial Production and Retail Sales number (undermined by an implausible CPI reading). President Xi and Premier Li have been talking down growth expectations but the punters themselves that they will be saved from ruin by the omnipotent PBoC. The parallels with investor attitudes to the FOMC and ECB are really scary.

Central bankers: not waving but drowning

Last week I rashly proposed a four-fold classification of Fed-watchers between Conspiracy Cynics, Incompetence Cynics, Selectively Naïve and Deluded Naïve, which met with a gratifying favourable reception from readers. Emboldened, I put forward this week a three-fold classification of all central bankers between Deluded, Baffled and Realistic. This may sound mischievous but it is meant to highlight the dark side of the common acceptance that global markets are now driven by the actions of less than 50 people, many of whom appear to be out of their depth.

The ten members of the FOMC were centre-stage last week and through the combination of their economic projections, post-meeting statement and press conference managed to display sufficient ambiguity to spark a rally in global equities and US Treasuries while sending the dollar into reverse. To be fair, probably only William Dudley and Charles Evans are candidates for the deluded classification while the three other regional Fed presidents seem to feel able to talk about raising rates sooner than later. However, Janet Yellen and her four fellow Board Governors still appear unable to move on from the orthodoxy of the Bernanke regime, despite its clearly not working.

The label ‘deluded’ seems especially appropriate to attach to Haruhiko Kuroda and the majority of his BoJ monetary policy colleagues who persist with QE and ZIRP (zero-interest rate policy) despite the conspicuous lack of evidence that they have boosted either growth or inflation in Japan. However, even he has most recently shown some signs of disagreement with the Abe government’s wishful thinking. Also seemingly deluded is Mario Draghi in his mission to re-ignite the EZ economy along the way to effecting political union. While a majority of the ECB governing council clearly agree with Mr Draghi he also faces determined opposition led by Bundesbank President Weidmann, who, in this matter at least, speaks with the voice of reason. In contrast, the PBoC’s Zhou Xiaochuan is something of a realist in terms of resisting ZIRP and currency depreciation despite political pressure from the top CP leadership.

Vanity rather than delusion may have characterised hitherto Governor Mark Carney’s various attempts to appear in charge of the UK economy and, indeed, the MPC has sensibly declined to cut Base Rate below 0.5% or to increase QE. However, most recently there have been signs within the Bank of England of at least some support for further easing. Last week’s speech from Chief Economist Andy Haldane looked suspiciously like kite-flying for one or more Base Rate cuts and the topic has also appeared in recent MPC minutes.

The increasingly awkward reality for central bankers is that QE and ZIRP may well have saved the US housing and UK gilt markets but have not done much since other than release a flood of liquidity in and, in the case of Emerging Markets and commodities, out of speculative punts around the globe. Hot money flows seem unlikely to stop sloshing hither and thither unless either the central banks stop easing (a decision apparently still being ducked by the FOMC) or investors decide enough is enough. Since the turn of the year there have been signs of growing unease amongst investors in US equities but EZ, Japanese and (domestic) Chinese markets are running hotter than ever and even the UK looks is joining the party. Meanwhile, dollar (and sterling) bond investors and issuers have understandably given up waiting for higher official rates and something little short of a speculative frenzy has broken out in European bonds. Never known to miss out on speculation, the currency market has been re-energised by various central banks’ attempts to depreciate their own currencies. In fact, the main and blatant purpose of the ECB and BoJ‘s QE programmes is to devalue the euro and yen in order to stimulate exports.

For now alas, the realists amongst central bankers are in the minority despite the obvious futility of using monetary policy to stimulate demand at a time when so many consumers are worrying about their jobs or are unemployed, when public and private debt levels are already elevated, when trade is buffeted by competitive currency devaluations and when so many companies prefer share buybacks to new investment. It seems that whether out of delusion or bafflement many central bankers have (to borrow from poet Stevie Smith) ‘gone further out than you thought and’ (soon may be) ‘drowning not waving’.

Greece and Germany: yang and ying

Even by the highest/lowest EMU standards of politicking the Greece situation is getting both more blatant and complicated. Trying to understand what is going on is like peeling an onion only to find a walnut in the middle. Finance Minister Varoufakis seems to be enjoying himself exercising his game theories on his EMU counterparts, the former troika institutions and even his colleagues in Syriza but he is probably on his own in that regard. Perhaps the most intriguing development is his attempt to manipulate the EU Commission (which along with France appears to be actively supporting the Greek cause, including, it is thought, drafting the final letter of agreement) against the IMF and, of course, the Germans.

Figure 2. Greece’s Repayments Crunch

Greece febmar

One has to assume both Greece and Germany are going for ‘all or nothing’ in another game. The Syriza government seems intent, after all, on seeking unprecedented debt relief from the IMF and the ECB (nothing is due to the EMU bail-out fund until 2023) while sticking to most of its election programme despite promising not to. This is making it more difficult for the EMU federalists to lean on and/or outmanoeuvre the Germans and their allies in the North and (now also) in Iberia. In fact, it is a threat to the whole EMU project as the Germans also seem willing to accept the risk of collateral damage if Grexit were to occur. Mr Schäuble is not as isolated as Syriza say (hope) he is in his insisting that they stick to the bail-out programme as amended by last week’s accord. Nor is he contemplating handing over any new money before June and only after seeing real progress in Greece. (Although over the weekend in the usual confusing EMU way, Jeroen Dijsselbloem, Chairman of the Eurogroup of finance ministers, has hinted that some further emergency money might be made available.) Accordingly, the gaming makes Grexit still seem very possible. In fact, it could be that both Greece and Germany have given up on each other already and are using the next four months to plan the divorce.

Figure 3. European Manufacturing PMIs

fig 3 manufacturing pmi

Source: Markit

Meanwhile, there are signs that the EMU economy may have stopped getting worse, which is not the same as a recovery. Yet again, it needs to be stressed that disinflation and deflation boost GDP as they deteriorate and that this has flattered the strong Q4 GDP headline numbers from Germany and Spain. In other data released in February, Germany continues to fare best except for the Manufacturing PMI and Spain is showing the most signs of improvement if one looks beyond Unemployment. Despite the bold talk of reform, France and Italy are yet to report any concrete progress.

This week the ECB announces details of its QE programme, which few people apart from a majority of the Governing Council expect to generate much growth or inflation. At least the Bundesbank is preparing to participate….for now…. and grumbling as it does so. In another provocation to Berlin, the EU commission has granted without offering much explanation extensions to both France and Italy on the timetable to comply with EMU budget deficit rules. Any relaxation of austerity may be helpful for short-term economic activity but the further accumulation of public debt in some countries makes more likely some sort of rescheduling, which is exactly what the Germans fear.

Figure 4. European negative yield club

fig 4 negative yield club

For now, equity markets are still enjoying the rally that began with expectations of QE but it remains to be seen how much of the proceeds of monthly bond sales remains in Europe. QE expectations have also already taken bond yields into new territory with 30% of them estimated to be negative and, of course, most investors see little risk of EMU break up, even including Grexit. A weaker euro remains the most achievable targeted outcome of QE and, in fact, seems likely in almost every scenario, even if hot money from the US and Japan may get in the way in the short-term.

DAX: Is QE really that good for German companies? 


Source: Bloomberg

Two-year Spanish government bond yields:OMG! Might these go negative?


Source: Bloomberg