Thursday, July 21, 2011

Lest we forget the BOJ when we think of the US of A

In formulating rate expectations for the FED in the coming year, there are the usual measures from analysts forecasts to market measures, be they from the futures, forwards, or swaps market, or more exotic species such as implied probability modeling.
While no two economies are identical I think it remains useful -- from a pedagogical standpoint -- to recognize history as a teacher. The current Federal Reserve Chairman, Ben Bernanke, has done the utmost from a conventional monetarist standpoint to expand the FED's balance sheet, in an attempt to reflate the economy at the micro level in order to see the results in aggregate. This has not worked and is unlikely to without intervention through fiscal policy. In the aftermath of The Great Recession, there was much discussion of the shape of the recovery with many pointing to the so-called Zarnowitz Rule as predictor that the recovery would be V shaped. That wasn't the case; we remain in the horizontal portion of an L shaped recovery and the United States is likely to be mired with moribund employment growth and the aftermath of an asset bubble bursting as a liquidity trap situation is never pretty (see the chart of the Bank of Japan Target Rate since 1990).

When the BOJ lowered from 6% in June 1991 to 0.5% in September 1995 how many predicted that the 0.5% rate would hold for almost three years before being lowered again in September 1998?
When rates went to zero in February of 1999 who predicted that they would stay there till July 2000?
It is fully acknowledged that the United States does not have the structural problems of Japan but it does suffer from the sclerosis of a political class that is wholly removed from the realities of working life; the pre-requisite for political office remains either substantial wealth or the ability to raise massive campaign funding through one's social networks. Promethean policy initiatives given way to the rhetoric of the ridiculous. One century later, the works of Max Weber and the critique of C. Wright Mills remains as relevant as ever when view current events.

Wednesday, July 20, 2011

Mr. Gross weighs in on "the new normal"

Bill Gross, founder, managing director and co-CIO of PIMCO and generally considered the master bond investor of his generation has weighed in on what investors should expect going forward given the dynamics of debt deleveraging --which he terms as "structural headwinds"-- dragging growth in the developed world in today's FT piece: Developed world cannot thrive at 'stall speed'

After citing Rogoff and Reinhart's tome "This Time Is Different" and PIMCO's own "new normal" moniker for the post 2008 environment, Gross left us to ponder this crucial take away:

These risks and the associated two per cent growth stall speed have several overall investment implications. For one, risk spreads will be constantly volatile as good and bad news hit the tape intermittently. Sovereign credit spreads will be subject to rather desperate policy endgames and equity and corporate bond risk spreads will follow in line despite the overall health of the corporate sector in the current upturn. Secondly, investors should expect an extended period of “financial repression” during which policy rates are kept extraordinarily low. Picking the pockets of investors and savers is an historically validated manoeuvre to re balance sovereign balance sheets. Instead of an inflation plus one per cent policy rate which has characterised the past thirty years, we must get used to inflation minus one or two per cent, a dramatic reversal in the fortunes of financial markets.

The expected negative real-policy rate will influence much of the US Treasury curve as well. Like a black hole, twenty-five basis point interest rates suck two and five year rates down with them, producing shockingly low returns that cannot possibly cope with the higher inflation they produce. Alternatively, thirty year rates stay high for fear of inflationary consequences in future decades. The result is a dramatically steep yield curve that promotes roll-down strategies as bonds appreciate in value as yields decline over time and, for banks and hedge funds, levered positions which take bets on duration, as opposed to on credit risk.
(emphasis added by me)

The US Federal Reserve's intervention in the fixed income and money markets (QE & QE2) has been a fascinating exercise in applied monetary economics. Conventional wisdom would have forecasted rising rates along the yield curve after June 30, 2011. Instead, the influence of end of quarter balance sheet window dressing by banks and other financial firms, the flooding of cash into the money market, and the FDIC's deposit insurance fee have all played a part in the further lowering of rates in the repo market (a colleague of mine was asked to provide cash --i.e. a negative return-- in exchange for collateral in the immediate aftermath of QE2 ending.

No policies work in isolation especially under such circumstances where the veneer of economic stability is removed. Conventional neoclassical economics sells students the idea of the primacy of monetary policy and the notion of fiscal policy being a blunt instrument given the long and variable lags in policy implementation and the inherent counter cyclical stabilizers present in capitalist economies with safety nets. This is a false idea; fiscal policy remains of inordinate importance.

Moreover, it is an intrinsic part of the human condition that as a species we have short memories and no sense of history hence the idea of a liquidity trap happening here was incomprehensible to those in the West when Japan grappled with it during the 1990s, the first decade of its lost decades; living through one illustrates the predicament of conventional thought.
Bill Gross' opinion is not conventional: I think that "we must get used to inflation minus one or two per cent" policy rates is spot on; the implication is that the idea of rate normalization touted by central banks is a false one. There will be intermittent bouts of commodity inflation to confuse matters but the "wage push inflation" that central banks are leery of will not occur unless there is a dramatic and (in my opinion) highly unlikely push to the left in the corridors of political power in advanced economies.

Monday, July 18, 2011

How will China's housing bubble end?

The more things change --another bout of sovereign debt concerns in the eurozone periphery; grandstanding in Washington; heightened demand for gold-- the more they stay the same.

The dynamics of the global capitalist system has left me convinced that a major correction --if not crash-- is likely in 2011-12 given that nothing has been changed fundamentally in a structural sense: imbalances remain while rhetoric reigns.

Here is a piece worth reading on The Chinese house-price bubble by Christian Dreger and Yanqun Zhang from the website. Here is a key take-away from the article:

Because of the integration of China into the world economy, a bursting bubble can cause negative spillovers to other countries, particularly in the Asian region. The challenge for the government is to scrap out speculative activities without killing an engine of GDP growth.
Just how the spillovers mentioned above will transpire is anyone's guess but one does not have to be a screaming Cassandra to recognize that amongst the industrialized economies, it is Australia --as China's commodity exporter of choice-- that is most vulnerable. Will Australia regret its booming business with China? The mining magnates such as Clive Palmer will be sheltered given their billions but the Australian public in general, and highly indebted middle class in particular will be vulnerable.

The taming of inflation in China, and elsewhere for that matter, will be done on the backs of those who can least afford it via a bursting of the asset bubble and ensuing high unemployment amongst lower and middle income earners. If the skilled mandarins in the CPC and PBOC are able to generate a soft rather than hard landing then they will rightly lay claim to being the world's best. Time will tell if they can manage to do so amid a highly financialized and increasingly volatile global system.