The General Manager for the Bank of International Settlements – the central bank of central bankers – is planning for “absolute control” of the money we all spend.
The General Manager for the Bank of International Settlements – the central bank of central bankers – is planning for “absolute control” of the money we all spend.
Ptolemy I Soter, in his history of the wars of Alexander the Great, related an episode from Alexander’s 334 BC compact with the Celts ‘who dwelt by the Ionian Gulf.’ According to Ptolemy’s account, which survives via quote by Arrian of Nicomedia some 450 years later, when Alexander asked the Celtic envoys what they feared most, they answered:
“We believe monetary policy is in a good place.”
– Federal Reserve Chairman Jerome Powell, October 30, 2019.
“We fear no man: there is but one thing that we fear, namely, that the sky should fall on us.”
Today, at the risk of being called Chicken Little, we tug on a thread that weaves back to the ancient Celts. Our message is grave: The sky is falling. Though the implications are still unclear.The sky, for our purposes, is the debt based dollar reserve standard that has been in place for the past 48 years. If you recall, on August 15, 1971, President Nixon “temporarily” suspended convertibility of the dollar into gold. The dollar became wholly the fiat money of the Treasury.
At the G-10 Rome meeting held in late-1971, Treasury Secretary John Connally reduced the new dollar reserve standard to a bite-sized nugget for his European finance minister counterparts, stating:
Predictably, without the restraint of gold, the quantity of debt based money has increased seemingly without limits – and it is everyone’s massive problem. What’s more, over the past 30 years the Federal Reserve has obliged Washington with cheaper and cheaper credit.
“The dollar is our currency, but it’s your problem.”
Hence, public, private, and corporate debt levels in the U.S. have multiplied beyond comprehension. Total US debt is now on the order of $74 trillion. \The consequences, no doubt, are an economy that is equally distorted and disfigured beyond comprehension.
America is no longer a dynamic, free-market economy. Rather, the economy is stagnant and operates under the central planning authority of Washington and the Fed. The illusion of prosperity is simulated by spending trillions of dollars funded by history’s greatest debt bubble.
Simple arithmetic shows the country is headed for economic catastrophe. Clearly, Social Security and Medicare face long-term financial challenges. Current workers must shoulder a greater and greater burden to pay for the benefits of retired workers.
At the same time, the world that brought the debt based dollar reserve standard into being no longer exists. Yet the dollar reserve standard and the Federal Reserve still remain as legacy institutions.
The divergence between the world as it exists – with its massive trade imbalances, massive debt loads, wealth inequality, and inflated asset prices – and the legacy dollar reserve standard is irreversible. Unless the unstable condition that has developed is allowed to transform naturally, there will be outright collapse.
Rather than adopting policies that allow for economic transformation and minimizing the ultimate disruption of a collapse, today’s planners and policy makers are doing everything they can to hold the failing financial order together. They are deeply invested academically and professionally; their livelihoods depend on it.
You see, selective blind spots of the best and brightest are normal when the sky is falling. For example, in 1989, just two years before the Soviet Union collapsed, Paul Samuelson – the “Father of Modern Day Economics” – and co-author William Nordhaus, wrote:
“The Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive.” – Paul Samuelson and William Nordhaus, Economics, 13th ed. [New York: McGraw Hill, 1989], p. 837.
Could Samuelson and Nordhaus possibly have been more clueless?
On Wednesday, following the October federal open market committee (FOMC) meeting, the Federal Reserve stated that it will cut the federal funds rate 25 basis points to a range of 1.5 to 1.75. No surprise there.
But the real insights were garnered several days earlier. Leading up to the FOMC meeting Fed Chair Jerome Powell received some public encouragement from one of his former cohorts – former President of the Federal Reserve Bank of New York, Bill Dudley. What follows is an excerpt of Dudley’s mental diarrhea, which he released in a Bloomberg Opinion article on Monday:
Dudley, like Samuelson, believes he can aggregate economic data and plot it on a graph; and, then, by fixing the price of credit, he can make the graphs appear more to his liking. He also believes he can preempt a recession by making ‘insurance’ rate cuts to stimulate the economy.
“People shouldn’t be as worried as they are about the risk of a U.S. recession. That said, it wouldn’t take much to trigger one, which is why the Federal Reserve should take out some insurance by providing added stimulus this week.
“Sometimes, an adverse event and human psychology can reinforce each other in such a way that they bring about a recession. Given how slowly the economy is growing, even a modest shock could do the trick.
“This danger bolsters the argument for the Fed to ease monetary policy at this week’s meeting of the Federal Open Market Committee. Such a preemptive move will reduce the chances that the economy will slow sufficiently to hit stall speed. Even if the insurance turns out to be unnecessary, the potential consequences aren’t bad. It just means that the economy will be stronger and the inflation rate will likely move more quickly back toward the Fed’s 2 percent target.”
Like Samuelson, Dudley doesn’t have a clue. The Fed cannot preemptively stop a recession. And after the dot com bubble and bust, the housing bubble and bust, the great financial crisis, zero interest rate policy, negative interest rate policy, quantitative easing, operation twist, quantitative tightening, reserve management, and many other failures, the Fed’s standing is clear to everyone but Dudley…
The Federal Reserve is a barbarous relic. The next downturn will be its death knell. Alas, what comes after the Fed will probably be even worse. Populism demands it.
Having destroyed discipline, central banks have no way out of the corner they’ve painted us into.
It was such a wonderful fantasy: just give a handful of bankers, financiers and corporations trillions of dollars at near-zero rates of interest, and this flood of credit and cash into the apex of the wealth-power pyramid would magically generate a new round of investments in productivity-improving infrastructure and equipment, which would trickle down to the masses in the form of higher wages, enabling the masses to borrow and spend more on consumption, powering the Nirvana of modern economics: a self-sustaining, self-reinforcing expansion of growth.
But alas, there is no self-sustaining, self-reinforcing expansion of growth; there are only massive, increasingly fragile asset bubbles, stagnant wages and a New Gilded Age as the handful of bankers, financiers and corporations that were handed unlimited nearly free money enriched themselves at the expense of everyone else.
When credit is nearly free to borrow in unlimited quantities, there’s no need for discipline, and so a year of university costs $50,000 instead of $10,000, houses that should cost $200,000 now cost $1 million and a bridge that should have cost $100 million costs $500 million. Nobody can afford anything any more because the answer in the era of central bank “growth” is: just borrow more, it won’t cost you much because interest rates are so low.
And with capital (i.e. saved earnings) getting essentially zero yield thanks to central bank ZIRP and NIRP (zero or negative interest rate policies), then all the credit has poured into speculative assets, inflating unprecedented asset bubbles that will destroy much of the financial system when they finally pop, as all asset bubbles eventually do.
Nobody knows what the price of anything is in the funny-money era of central banks. And since capital earns next to nothing, the only way to earn a return is join the mad frenzy chasing risk assets ever higher, with the plan being to sell at the top to a greater fool, a strategy few manage as it requires selling into a rally that seems destined to climb to the stars.
Having destroyed discipline–why scrimp and save when you can always borrow to buy or invest?– central banks have no way out of the corner they’ve painted us into. If they “normalize” interest rates to historical averages (3% above real-world inflation), then all the zombie companies and households that are surviving only because rates are near-zero will go bankrupt, wiping out the “wealth” of all the loans that can no longer be paid.
“Normalized” rates would also bring down the global housing bubble, an implosion that would trigger trillions in losses, reversing the vaunted wealth effect into a realization that we’re all getting poorer, not richer, and collapsing the risky mountain of mortgage debt that’s been piled on absurdly overvalued properties globally.
In effect, central banks added a zero to “money” and anticipated that this trickery would generate ten times more of everything: ten times more productive investments, ten times more consumption, ten times more people borrowing ten times more money, and so on.
But the trickery failed, and all we have is $200,000 houses that cost $1 million, a year in college that costs $50,000 instead of $10,000, and so on.Having destroyed discipline and price discovery, central banks attempted to replace reality with fantasy, and now the absurd fantasy is imploding. The financial system and the real-world economy have both been destabilized by this fantasy, and now both are fragile in ways few understand.
The only “policies” central banks have is to issue more credit at negative interest rates, i.e. doing more of what’s failed spectacularly, until the entire rickety travesty of a mockery of a sham collapses.
That collapse is currently underway in slow motion, but given the increasing instability of asset bubbles, it could accelerate at any time.
Quote Of The Pre-War Era…
The Federal Reserve Resistance: A recent official urges the central bank to help defeat Donald Trump.
Perhaps you’ve seen former Chairs of the Federal Reserve defending the central bank’s independence and fore swearing all political intentions. Fair enough. But then what are we to make of former Fed monetary Vice Chair William Dudley ’s marker that the Fed should help defeat President Trump in 2020? That’s the extraordinary message from the former, and perhaps future, Fed grandee in Bloomberg.
“Officials could state explicitly that the central bank won’t bail out an administration that keeps making bad choices on trade policy, making it abundantly clear that Trump will own the consequences of his actions,” Mr. Dudley asserts. We also think monetary policy should focus on prices rather than trade. But Mr. Dudley seems to be saying the Fed should do nothing to assist the economy even if it heads into recession. Then he goes further and essentially says the Fed should join The Resistance.
“There’s even an argument that the election itself falls within the Fed’s purview,” Mr. Dudley writes. “After all, Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”
Wow. Talk about stripping the veil. These columns wondered if Mr. Dudley was politically motivated while he was at the Fed, favoring bond buying to finance Barack Obama ’s deficit spending, urging the Fed to intervene in markets to boost housing, and keeping interest rates low for as long as possible. And now here Mr. Dudley is confirming that he views the Fed as an agent of the Democratic Party.
A key lesson of the Trump era is that every single allegedly neutral, nonpartisan, super-professional institution has turned out to be, in fact, a bunch of partisan hacks shilling for the permanent political party. Voters can be forgiven for adopting a “burn it all down” attitude in response.
While the Fed has been engaging in quantitative tightening for over a year now in an attempt to shrink its asset holdings, it still has over $4.1 trillion in bonds on its balance sheet, and as a result of the spike in yields since last summer, their massive portfolio has suffered substantial paper losses which according to the Fed’s latest quarterly financial report, hit a record $66.453 billion in the third quarter, raising questions about their strategy at a politically charged moment for the central bank, whose “independence” has been put increasingly into question as a result of relentless badgering by Donald Trump.
What immediately caught the attention of financial analysts is that the gaping Q3 loss of over $66 billion, dwarfed the Fed’s $39.1 billion in capital, leaving the US central bank with a negative net worth…
… which would suggest insolvency for any ordinary company, but since the Fed gets to print its own money, it is of course anything but an ordinary company as Bloomberg quips.
It’s not just the fact that the US central bank prints the world’s reserve currency, but that it also does not mark its holdings to market. As a result, Fed officials usually play down the significance of the theoretical losses and say they won’t affect the ability of what they call “a unique non-profit entity’’ to carry out monetary policy or remit profits to the Treasury Department. Indeed, confirming this the Fed handed over $51.6 billion to the Treasury in the first nine months of the year.
The risk, however, is that should the Fed’s finances continue to deteriorate if only on paper, it could impair its standing with Congress and the public when it is already under attack from President Donald Trump as being a bigger problem than trade foe China.
Commenting on the Fed’s paper losses, former Fed Governor Kevin Warsh told Bloomberg that “a central bank with a negative net worth matters not in theory. But in practice, it runs the risk of chipping away at Fed credibility, its most powerful asset.’’
Additionally, the growing unrealized losses provide fuel to critics of the Fed’s QE and the monetary operating framework underpinning them, just as central bankers begin discussing the future of its balance sheet. And, as Bloomberg cautions, the metaphoric red ink also could make it politically more difficult for the Fed to resume QE if the economy turns down.
“We’re seeing the downside risk of unconventional monetary policy,’’ said Andy Barr, the outgoing chairman of the monetary policy and trade subcommittee of the House Financial Services panel. “The burden should be on them to tell us why this does not compromise their credibility and why the public and Congress should not be concerned about their solvency.’’
Of course, the culprit for the record loss is not so much the holdings, as the impact on bond prices as a result of rising rates which spiked in the summer as a result of the Fed’s own overoptimism on the economy, and which closed the third quarter at 3.10% on the 10Y Treasury. Indeed, with rates rising slower in the second quarter, the loss for Q3 was a more modest $19.6 billion.
And with yields tumbling in the fourth quarter as a result of the current growth and markets scare, it is likely that the Fed could book a major “profit” for the fourth quarter as the 10Y yield is now trading just barely above the 2.86% where it was on June 30.
Meanwhile, the Fed continues to shrink its bond holdings by a maximum of $50 billion per month, an amount that was hit on October 1, not by selling them, which could force it to recognize but by opting not to reinvest some of the proceeds of securities as they mature.
The Fed is expected to continue shrinking its balance sheet at rate of $50BN / month until the end of 2020 (as shown below) unless of course market stress forces the Fed to halt QT well in advance of its tentative conclusion.
In any case, the Fed will certainly never return to its far leaner balance sheet from before the crisis, which means that it will continue to indefinitely pay banks interest on the excess reserves they park at the Fed, with many of the recipient banks being foreign entities.
Barr, a Kentucky Republican, has accurately criticized that as a subsidy for the banks, one which will amount to tens of billions in annual “earnings” from the Fed, the higher the IOER rate goes up. He is not alone: so too has California Democrat Maxine Waters, who will take over as chair of the House Financial Services Committee in January following her party’s victory in the November congressional elections.
* * *
Going back to the Fed’s unique treatment of losses on its income statement and its under capitalization, in an Aug. 13 note, Fed officials Brian Bonis, Lauren Fiesthumel and Jamie Noonan defended the central bank’s decision not to follow GAAP in valuing its portfolio. Not only is the central bank a unique creation of Congress, it intends to hold its bonds to maturity, they wrote.
Under GAAP, an institution is required to report trading securities and those available for sale at fair or market value, rather than at face value. The Fed reports its balance-sheet holdings at face value.
The Fed is far less cautious with the treatment of its “profits”, which it regularly hands over to the Treasury: the interest income on its bonds was $80.2 billion in 2017. The central bank turns a profit on its portfolio because it doesn’t pay interest on one of its biggest liabilities – $1.7 trillion in currency outstanding.
The Fed’s unique financial treatments also extends to Congress, which while limiting to $6.8 billion the amount of profits that the Fed can retain to boost its capital has also repeatedly “raided” the Fed’s capital to pay for various government programs, including $19 billion in 2015 for spending on highways.
Still, a negative net worth is sure to raise eyebrows especially after Janet Yellen said in December 2015 that “capital is something that I believe enhances the credibility and confidence in the central bank.”
* * *
Furthermore, as Bloomberg adds, if it had to the Fed could easily operate with negative net worth – as it is doing now – like other central banks in Chile, the Czech Republic and elsewhere have done, according to Nathan Sheets, chief economist at PGIM Fixed Income. That said, questionable Fed finances pose communications and mostly political problems for Fed policymakers.
As for long-time Fed critic and former Fed governor, Kevin Warsh, he zeroed in on the potential impact on quantitative easing.
“QE works predominantly through its signaling to financial markets,’’ he said. “If Fed credibility is diminished for any reason — by misunderstanding the state of the economy, under-estimating the power of QE’s unwind or carrying a persistent negative net worth — QE efficacy is diminished.’’
The biggest irony, of course, is that the more “successful” the Fed is in raising rates – and pushing bond prices lower – the greater the un-booked losses on its bond holdings will become; should they become great enough to invite constant Congressional oversight, the casualty may be none other than the equity market, which owes all of its gains since 2009 to the Federal Reserve.
While a central bank can operate with negative net worth, such a condition could have political consequences, Tobias Adrian, financial markets chief at the IMF said. “An institution with negative equity is not confidence-instilling,’’ he told a Washington conference on Nov. 15. “The perception might be quite destabilizing at some point.”
That point will likely come some time during the next two years as the acrimonious relationship between Trump and Fed Chair Jerome Powell devolves further, at which point the culprit by design, for what would be the biggest market crash in history will be not the Fed – which in the past decade blew the biggest asset bubble in history – but President Trump himself.
We present some somber reading on this holiday season from Macquarie Capital’s Viktor Shvets, who in this exclusive to ZH readers excerpt from his year-ahead preview, explains why central banks can no longer exit the “doomsday highway” as a result of a “dilemma from hell” which no longer has a practical, real-world resolution, entirely as a result of previous actions by the same central bankers who are now left with no way out from a trap they themselves have created.
* * *
“It has been said that something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world” – Chaos Theory.
There is a good chance that 2018 might fully deserve shrill voices and predictions of dislocations that have filled almost every annual preview since the Great Financial Crisis.
Whether it was fears of a deflationary bust, expectation of an inflationary break-outs, disinflationary waves, central bank policy errors, US$ surges or liquidity crunches, we pretty much had it all. However, for most investors, the last decade actually turned out to be one of the most profitable and the most placid on record. Why then have most investors underperformed and why are passive investment styles now at least one-third (or more likely closer to two-third) of the market and why have value investors been consistently crushed while traditional sector and style rotations failed to work? Our answer remains unchanged. There was nothing conventional or normal over the last decade, and we believe that neither would there be anything conventional over the next decade. We do not view current synchronized global recovery as indicative of a return to traditional business and capital market cycles that investors can ‘read’ and hence make rational judgements on asset allocations and sector rotations, based on conventional mean reversion strategies. It remains an article of faith for us that neither reintroduction of price discovery nor asset price volatility is any longer possible or even desirable.
However, would 2018, provide a break with the last decade? The answer to this question depends on one key variable. Are we witnessing a broad-based private sector recovery, with productivity and animal spirits coming back after a decade of hibernation, or is the latest reflationary wave due to similar reasons as in other recent episodes, namely (a) excess liquidity pumped by central banks (CBs); (b) improved co-ordination of global monetary policies, aimed at containing exchange rate volatility; and (c) China’s stimulus that reflated commodity complex and trade?
The answer to this question would determine how 2018 and 2019 are likely to play out. If the current reflation has strong private sector underpinnings, then not only would it be appropriate for CBs to withdraw liquidity and raise cost of capital, but indeed these would bolster confidence, and erode pricing anomalies without jeopardizing growth or causing excessive asset price displacements. Essentially, the strength of private sector would determine the extent to which incremental financialization and public sector supports would be required. If on the other hand, one were to conclude that most of the improvement has thus far been driven by CBs nailing cost of capital at zero (or below), liquidity injections and China’s debt-fuelled growth, then any meaningful withdrawal of liquidity and attempts to raise cost of capital would be met by potentially violent dislocations of asset prices and rising volatility, in turn, causing contraction of aggregate demand and resurfacing of disinflationary pressures. We remain very much in the latter camp. As the discussion below illustrates, we do not see evidence to support private sector-led recovery concept. Rather, we see support for excess liquidity, distorted rates and China spending driving most of the improvement.
We have in the past extensively written on the core drivers of current anomalies. In a ‘nutshell’, we maintain that over the last three decades, investors have gradually moved from a world of scarcity and scale limitations, to a world of relative abundance and an almost unlimited scalability. The revolution started in early 1970s, but accelerated since mid-1990s. If history is any guide, the crescendo would occur over the next decade. In the meantime, returns on conventional human inputs and conventional capital will continue eroding while return on social and digital capital will continue rising. This promises to further increase disinflationary pressures (as marginal cost of almost everything declines to zero), while keeping productivity rates constrained, and further raising inequalities.
The new world is one of disintegrating pricing signals and where economists would struggle even more than usual, in defining economic rules. As Paul Romer argued in his recent shot at his own profession, a significant chunk of macro-economic theories that were developed since 1930s need to be discarded. Included are concepts such as ‘macro economy as a system in equilibrium’, ‘efficient market hypothesis’, ‘great moderation’ ‘irrelevance of monetary policies’, ‘there are no secular or structural factors, it is all about aggregate demand’, ‘home ownership is good for the economy’, ‘individuals are profit-maximizing rational economic agents’, ‘compensation determines how hard people work’, ‘there are stable preferences for consumption vs saving’ etc. Indeed, the list of challenges is growing ever longer, as technology and Information Age alters importance of relative inputs, and includes questions how to measure ‘commons’ and proliferating non-monetary and non-pricing spheres, such as ‘gig or sharing’ economies and whether the Philips curve has not just flattened by disappeared completely. The same implies to several exogenous concepts beloved by economists (such as demographics).
The above deep secular drivers that were developing for more than three decades, but which have become pronounced in the last 10-15 years, are made worse by the activism of the public sector. It is ironic that CBs are working hard to erode the real value of global and national debt mountains by encouraging higher inflation, when it was the public sector and CBs themselves which since 1980s encouraged accelerated financialization. As we asked in our recent review, how can CBs exit this ‘doomsday highway’?
Investors and CBs are facing a convergence of two hurricane systems (technology and over-financialization), that are largely unstoppable. Unless there is a miracle of robust private sector productivity recovery or unless public sector policies were to undergo a drastic change (such as merger and fiscal and monetary arms, introduction of minimum income guarantees, massive Marshall Plan-style investments in the least developed regions etc), we can’t see how liquidity can be withdrawn; nor can we see how cost of capital can ever increase. This means that CBs remain slaves of the system that they have built (though it must be emphasized on our behalf and for our benefit).
If the above is the right answer, then investors and CBs have to be incredibly careful as we enter 2018. There is no doubt that having rescued the world from a potentially devastating deflationary bust, CBs would love to return to some form of normality, build up ammunition for next dislocations and play a far less visible role in the local and global economies. Although there are now a number of dissenting voices (such as Larry Summers or Adair Turner) who are questioning the need for CB independence, it remains an article of faith for an overwhelming majority of economists. However, the longer CBs stay in the game, the less likely it is that the independence would survive. Indeed, it would become far more likely that the world gravitates towards China and Japan, where CB independence is largely notional.
Hence, the dilemma from hell facing CBs: If they pull away and remove liquidity and try to raise cost of capital, neither demand for nor supply of capital would be able to endure lower liquidity and flattening yield curves. On the other hand, the longer CBs persist with current policies, the more disinflationary pressures are likely to strengthen and the less likely is private sector to regain its primacy.
We maintain that there are only two ‘tickets’ out of this jail. First (and the best) is a sudden and sustainable surge in private sector productivity and second, a significant shift in public sector policies. Given that neither answer is likely (at least not for a while), a coordinated, more hawkish CB stance is akin to mixing highly volatile and combustible chemicals, with unpredictable outcomes.
Most economists do not pay much attention to liquidity or cost of capital, focusing almost entirely on aggregate demand and inflation. Hence, the conventional arguments that the overall stock of accommodation is more important than the flow, and thus so long as CBs are very careful in managing liquidity withdrawals and cost of capital raised very slowly, then CBs could achieve the desired objective of reducing more extreme asset anomalies, while buying insurance against future dislocation and getting ahead of the curve. In our view, this is where chaos theory comes in. Given that the global economy is leveraged at least three times GDP and value of financial instruments equals 4x-5x GDP (and potentially as much as ten times), even the smallest withdrawal of liquidity or misalignment of monetary policies could become an equivalent of flapping butterfly wings. Indeed, in our view, this is what flattening of the yield curves tells us; investors correctly interpret any contraction of liquidity or rise in rates, as raising a possibility of more disinflationary outcomes further down the road.
Hence, we maintain that the key risks that investors are currently running are ones to do with policy errors. Given that we believe that recent reflation was mostly caused by central bank liquidity, compressed interest rates and China stimulus, clearly any policy errors by central banks and China could easily cause a similar dislocation to what occurred in 2013 or late 2015/early 2016. When investors argue that both CBs and public authorities have become far more experienced in managing liquidity and markets, and hence, chances of policy errors have declined, we believe that it is the most dangerous form of hubris. One could ask, what prompted China to attempt a proper de-leveraging from late 2014 to early 2016, which was the key contributor to both collapse of commodity prices and global volatility? Similarly, one could ask what prompted the Fed to tighten into China’s deleveraging drive in Dec ’15. There is a serious question over China’s priorities, following completion of the 19th Congress, and whether China fully understands how much of the global reflation was due to its policy reversal to end deleveraging.
What does it mean for investors? We believe that it implies a higher than average risk, as some of the key underpinnings of the investment landscape could shift significantly, and even if macroeconomic outcomes were to be less stressful than feared, it could cause significant relative and absolute price re-adjustments. As highlighted in discussion below, financial markets are completely unprepared for higher volatility. For example, value has for a number of years systematically under performed both quality and growth. If indeed, CBs managed to withdraw liquidity without dislocating economies and potentially strengthening perception of growth momentum, investors might witness a very strong rotation into value. Although we do not believe that it would be sustainable, expectations could run ahead of themselves. Similarly, any spike in inflation gauges could lift the entire curve up, with massive losses for bondholders, and flowing into some of the more expensive and marginal growth stories.
While it is hard to predict some of these shorter-term moves, if volatilities jump, CBs would need to reset the ‘background picture’. The challenge is that even with the best of intentions, the process is far from automatic, and hence there could be months of extended volatility (a la Dec’15-Feb’16). If one ignores shorter-term aberrations, we maintain that there is no alternative to policies that have been pursued since 1980s of deliberately suppressing and managing business and capital market cycles. As discussed in our recent note, this implies that a relatively pleasant ‘Kondratieff autumn’ (characterized by inability to raise cost of capital against a background of constrained but positive growth and inflation rates) is likely to endure. Indeed, two generations of investors grew up knowing nothing else. They have never experienced either scorching summers or freezing winters, as public sector refused to allow debt repudiation, deleveraging or clearance of excesses. Although this cannot last forever, there is no reason to believe that the end of the road would necessarily occur in 2018 or 2019. It is true that policy risks are more heightened but so is policy recognition of dangers.
We therefore remain constructive on financial assets (as we have been for quite some time), not because we believe in a sustainable and private sector-led recovery but rather because we do not believe in one, and thus we do not see any viable alternatives to an ongoing financialization, which needs to be facilitated through excess liquidity, and avoiding proper price and risk discovery, and thus avoiding asset price volatility.
When Central Banks start buying, watch out
(MarketWatch) Bitcoin $55,000? Fundstrat’s Tom Lee, one of the biggest equity bears among the major Wall Street strategists, says it’s possible, but not necessarily for the reasons many bitcoin bulls have suggested.
“One of the drivers is crypto-currencies are cannibalizing demand for gold GCQ7, +0.12% ” Lee wrote in a report. “Based on our model, we estimate that bitcoin’s value per unit could be $20,000 to $55,000 by 2022 — hence, investors need to identify strategies to leverage this potential rise in crypto-currencies.”
That’s a major jump from the $2,530 level that bitcoin BTCUSD, -0.84% fetched recently. Of course, this would be on top of what’s already been an impressive stretch, with the price more than doubling since the start of the year.
Lee predicts investors will look to bitcoin as a gold substitute, and the fact that the amount of available bitcoin is reaching its limit makes this supply/demand story even more compelling for those looking to turn profits in the crypto market.
“Bitcoin supply will grow even slower than gold,” Lee said. “Hence, the scarcity of bitcoin is becoming increasingly attractive relative to gold.”
Another driver could come from central banks, which he expects will consider buying bitcoin if the total market cap hits $500 billion.
“This is a game changer, enhancing the legitimacy of the currency and likely accelerating the substitution for gold,” Lee wrote.
The trick is that there aren’t very many ways to play bitcoin, other than via direct investment or the bitcoin ETF GBTC, -1.75% he said, adding that “we will identify other opportunities in the future.”
One month ago, when observing the record low vol coupled with record high stock prices, we reported a stunning statistic: central banks have bought $1 trillion of financial assets just in the first four months of 2017, which amounts to $3.6 trillion annualized, “the largest CB buying on record” according to Bank of America. Today BofA’s Michael Hartnett provides an update on this number: he writes that central bank balance sheets have now grown to a record $15.1 trillion, up from $14.6 trillion in late April, and says that “central banks have bought a record $1.5 trillion in assets YTD.”
The latest data means that contrary to previous calculations, central banks are now injecting a record $300 billion in liquidity per month, above the $200 billion which Deutsche Bank recently warned is a “red-line” indicator for risk assets.
This, as we said last month, is why “nothing else matters” in a market addicted to what is now record central bank generosity.
What is ironic is that this unprecedented central bank buying spree comes as a time when the global economy is supposedly in a “coordinated recovery” and when the Fed, and more recently, the ECB and BOJ have been warning about tighter monetary conditions, raising rates and tapering QE.
To this, Hartnett responds that “Fed hikes next week & “rhetorical tightening” by ECB & BoJ beginning, but we fear too late to prevent Icarus” by which he means that no matter what central banks do, a final blow-off top in the stock market is imminent.
He is probably correct, especially when looking at the “big 5” tech stocks, whose performance has an uncanny correlation with the size of the consolidated central bank balance sheet.
One conundrum stumping investors in recent months has been how, with investors pulling money out of equity funds (at last check for 17 consecutive weeks) at a pace that suggests a full-on flight to safety, as can be seen in the chart below which shows record fund outflows in the first half of the year – the fastest pace of withdrawals for any first half on record…
… are these same markets trading at all time highs? We now have the answer.
Recall at the end of January when global markets were keeling over, that Citi’s Matt King showed that despite aggressive attempts by the ECB and BOJ to inject constant central bank liquidity into the gunfible global markets, it was the EM drain via reserve liquidations, that was causing a shock to the system, as net liquidity was being withdrawn, and in the process stocks were sliding.
Fast forward six months when Matt King reports that “many clients have been asking for an update of our usual central bank liquidity metrics.”
What the update reveals is “a surge in net global central bank asset purchases to their highest since 2013.”
And just like that the mystery of who has been buying stocks as everyone else has been selling has been revealed.
But wait, there’s more because as King suggests “credit and equities should rally even more strongly than they have done already.”
More observations from King:
The underlying drivers are an acceleration in the pace of ECB and BoJ purchases, coupled with a reversal in the previous decline of EMFX reserves. Other indicators also point to the potential for a further squeeze in global risk assets: a broadening out of mutual fund inflows from IG to HY, EM and equities; the second lowest level of positions in our credit survey (after February) since 2008; and prospects of further stimulus from the BoE and perhaps the BoJ.
While we remain deeply skeptical of the durability of such a policy-induced rally, unless there is a follow-through in terms of fundamentals, and in credit had already started to emphasize relative value over absolute, we suspect those with bearish longer-term inclinations may nevertheless feel now is not the time to position for them.
And some words of consolation for those who find themselves once again fighting not just the Fed but all central banks:
The problems investors face are those we have referred to many times: markets being driven more by momentum than by value, and most negatives being extremely long-term in nature (the need for deleveraging; political trends towards deglobalization; a steady erosion of confidence in central banks). Against these, the combination of UK political fudge (and perhaps Italian tiramisu), a lack of near-term catalysts, and overwhelming central bank liquidity risks proving overwhelming – albeit only temporarily.
Why have central banks now completely turned their backs on the long-run just to provide some further near-term comfort? Simple: as Keynes said, in the long-run we are all dead.
US GDP Output Gap Update – Q1 2016
Among our favorite indicators to write about is the GDP output gap. Today we update it with the latest Q1 2016 GDP data. We’ve written about it many times in the past (some recent examples: 09/30/2015, 12/27/2014, and 06/06/2014). It is the standard for representing economic slack in most other developed countries but is usually overlooked in the United States in favor of the gap between the unemployment rate and full employment (also called NAIRU (link is external). This is partially because the US Federal Reserve’s FOMC has one half of its main goal to promote ‘full employment’ (along with price stability) but it is also partially because the unemployment rate makes the economy look better, which is always popular to promote. In past US business cycles, these two gaps had a close linear relationship (Okun’s law (link is external) and so normally they were interchangeable, yet, in this recovery, the unemployment rate suggests much more progression than the GDP output gap.
The unemployment gap now, looked at on its face, would imply that the US is at full employment; i.e., the unemployment rate is 5% and full employment is considered to be 5%. Thus, this implies that the US economy is right on the verge of generating inflation pressure. Yet, the unemployment rate almost certainly overstates the health of the economy because of a sharp increase over the last many years of unemployed surveys claiming they are not involved in the workforce (i.e. not looking for a job). From the beginning of the last recession, November 2007, the share of adults claiming to be in the workforce has fallen by 3.0% of the adult population, or 7.6 million people of today’s population! Those 7.6 million simply claiming to be looking for a job would send the unemployment rate up to 9.4%!. In other words, this metric’s strength is heavily reliant on whether people say they are looking for a job or not, and many could switch if the economy was better. Thinking about this in a very simplistic way; a diminishing share of the population working still has to support the entire population and without offsetting higher real wages, this pattern is regressive to the economy. The unemployment rate’s strength misses this.
Adding to the evidence that the unemployment rate is overstating the health of the economy is the mismatch between the Bureau of Labor Statistics’ (BLS) household survey (unemployment rate) and the establishment survey (non-farm payroll number). Analyzing the growth in non-farm payrolls over the period of recovery (and adjusting for aging demographics) suggests that the US economy still has a gap to full employment of about 1.5 million jobs; this is the Hamilton Project’s Jobs Gap (link is external).
But, the labor market is a subset of the economy, and while its indicators are much more accessible and frequent than measurements on the entire economy, the comprehensive GDP output gap merits being part of the discussion on the economy. Even with the Congressional Budget Office (CBO) revising potential GDP lower each year, the GDP output gap (chart) continues to suggest a dis-inflationary economy, let alone a far away date when the Federal Reserve needs to raise rates to restrict growth. This analysis suggests a completely different path for the Fed funds rate than the day-to-day hysterics over which and how many meetings the Fed will raise rates this year. This analysis is the one that has worked, not the “aspirational” economics that most practice.
In an asset management context, US Treasury interest rates tend to trend lower when there is an output gap and trend higher when there is an output surplus. This simple, yet overlooked rule has helped to guide us to stay correctly long US Treasuries over the last several years while the Wall Street community came up with any reason why they were a losing asset class. We continue to think that US Treasury interest rates have significant appreciation ahead of them. As we have stated before, we think the 10yr US Treasury yield will fall to 1.00% or below.