Macro | How Sustainable is the US Dollar Rally

The dollar rally that started since the conclusion of US presidential election shows not much signs of abatement. 2014 was the year of crude oil, when the fantastic sell-off in crude set much of the moods prevailing in the world economy - from equities to rates. In 2015, this slowly turned over to dollar, partly through the surprise CNY depreciation, and later through Fed rate hike expectation. And without any doubt, despite all the noises around the Brexit and Italian referendum votes (early Dec), the dominating factor for risks is again US dollars. The figure below shows a quantitative look at the cross market risk drivers using Minimum Spanning Tree methodology (based on correlation). It shows clearly the dollar is in the center of the cross market driving force. A very similar situation to what we had back in 2013, but more concentrated role for the dollars to set the market sentiments. We already had a not-so-quite riot in rates following the dollar strength post election. The emerging market currencies and equities have taken significant beatings. And top houses are calling for this dollar strength to be one of the top trades in 2017. Naturally it begs the question how much leg is still left in this dollar rally.

To take a long-term look, the dollar rally is by no means extreme. In nominal terms the broad-based trade weighted dollar index is near its historical highs. However, when we compensate for the inflation differentials between the US and its trade partners, the rally is well within the historical range (still 13% off from the 2002 peak) - as the chart below shows. Note the rally in dollar since 2014 has been almost equal for the real and nominal exchange rate - 17% vs 20%.

But while this rally may not be extreme, it may not be sustainable either. A large part of the recent dollar strength has been on the back of expectation of US policy change, specifically a possible fiscal stimulus. The economic argument behind is that a fiscal stimulus, coupled with a budget deficit will increase interest rates and hence the exchange rate. In fact this is what was observed during early 1980s in the US (although it has not much support from observations in other non-US advanced economies). The actual mechanism is far from clear. There are extensive studies on budget deficit reduction and its impact on exchange rates, but reverse studies are rare. Theoretically, the direct impact (of increasing budget deficit) goes through the interest rate and asset return channel above and lead to a higher exchange rate (as demand for higher interest assets goes up among foreigners). On the other hand, increased budget deficit can increase the long term inflation expectation and hence expectation of future dollar depreciation. The second part of the policy is trade - which is basically a tightening pressure on the US current account deficit - if President-elect Trump follows though his promises. Typically for the US the current account in recent history has been driven to a large extent by demand for financials assets from overseas investors. This means a tightening of current account will have to be matched by reduced demand for US financial assets by foreign investors, resulting in a currency depreciation now (and possibly an appreciation later). In fact the post-crisis dollar weakness has resulted in a significant tightening of current account for the US already. A further sustained tightening in general may not be great for either the US or global economy. The other possible factors, i.e. the overall demand (or GDP differential) or real rate differential with major trading partners are relatively straightforward, an increase in both leading to a stronger dollar.

Looking in to the above set of arguments empirically, we run a quick vector auto-regression estimates with real dollar exchange rate, real rate differential, current account (% GDP), budget balance (% GDP) and GDP differential as endogenous variables (differential with GDP-weighted Euro area and Japan data representing rest of the world). The results are as shown in terms of impulse response - i.e. response of dollar real exchange rate for unit positive move in budget balance (FD), current account balance (ca), real rates differential (rates) and GDP differential (GDP). It seems at least for our data (spanning 1995 to 2014, quarterly), Trumps policy of budget deficit (negative fd) and tightening current account (positive ca) has off-setting impact for dollar real exchange rate. In fact there are good chances the current account tightening impact (negative for dollar in near term, positive long term) can overwhelm. An increase interest rates may make US assets attractive among foreign investors, but without matching trades the flows in to those assets will be difficult to sustain. Among other drivers, while inflation in US has been steady, including wage growth, we have seen some early signs of a come back of inflation in the Euro area. The main thing to look out there is the pick up in Euro area credit growth after a stall start of this year.

Given this ambiguous impact of policy, and hopefully a declining need for policy divergence and a head-room for trade-weighted dollars of only ~13% to reach all time high in real terms, it does not look like the dollar rally has much room left. one of the surprise trigger can come from ECB and/or BoJ in December, with QE in Europe still priced in. And the Dec Fed hike - which is almost a certainty now - will act to defuse this rally. 

Interestingly, while from the emerging market point of view, the recent dollar rally was kind of risk-off, it was hardly so for Euro. Euro - which has lately became a funding currency like the Yen, sold off steeply. Arguably there was not much positioning to blame either, so this makes it a very interesting move. The Euro area as a whole has accumulated a huge current account surplus in its glut for savings in the post-crisis period. A substantial change in trade relationship with the US may start to unravel that. If you are positioning for the consensus Euro dollar parity, think again. 2017 may see a major reversal in Euro instead dollar.

Note: all data from the St Louis Fed FRED database.

Central Bank Watch: FOMC Minutes (and RBI)

It is highly interesting to see the views and counter-views on the impact of  low rates on the DCF industry. I think both miss the subtle point here . All these DCFs and PVs and pretty much everything else depends on an assumption of properly functioning lending and borrowing market. The question is: if negative rate does persist for long, will that assumption breakdown, or will adapt.

Speaking of rates, the FOMC minutes released this week was very informative. It was a much ambivalent FOMC than we have seen earlier. It appears the September hold decision was a close call. So it is safe to assume it will be so in November and December (if no hike in Nov) as well.

On the major points that drives the"data dependent" FOMC, it seems the consensus is on the labor markets. Since the last meetings, we had more or less similar or slightly improved wage data. However, this week's job opening (JOLT) was a bit disappointing. On economic growth expectation, retails sales data from Friday was more or less on the mark, matching street expectation, and capital goods from earlier has shown improvement as well. Even the much discussed negative influence of foreign GDP has subsided. Eurozone forecast edged up to 1.3% from 1.2%, and UK forecasts from 0.50% to 0.70% (since Sep FOMC). 

However, surprisingly, on both of these parameters, Fed's own measure is going the other way. The Labor Market Condition Index and the Atlanta Fed's GDP now-casting have both nose-dived in recent readings.

On the inflation front, the both the CPI and PCE edged up since. The CPI is still suffering from energy prices drag. Given the recent moves in oil prices, this should have a positive impact on data before the next meeting. 

Overall, I expect the data to be neutral for both employment and growth and marginally hawkish for inflation for the November meeting. The possibility of a November hike is still lower. Partly, that will be a surprise for the markets - which currently prices in a 17% chance of a hike at November FOMC and a 64% at the Dec meeting. As I discussed before, Fed has never hiked before without a substantial chance priced in by the markets.

That said, one particular line of arguments stands out from the released minutes:

 A few participants referred to historical episodes when the unemployment rate appeared to have fallen well below its estimated longer-run normal level. They observed that monetary tightening in those episodes typically had been followed by recession and a large increase in the unemployment rate. Several participants viewed this historical experience as relevant for the Committee's current decisionmaking and saw it as providing evidence that waiting too long to resume the process of policy firming could pose risks to the economic expansion, or noted that a significant increase in unemployment would have disproportionate effects on low-skilled workers and minority groups.

There were only two major hike cycles not followed by a rise in unemployment in recent history. One was following the early 80s recession, and the other following the early 90s recession. 

This points towards a strong commitment of FOMC towards a gradual rate hike, even if the initial hike has to be brought forward in time. It will be very surprising if we do not have another hike by the end of the year. But this, along with the now-lower long term equilibrium rates, also means it will NOT be particularly threatening to US equities or rates in general (both slopes and levels). Fade the move if any respond violently to FOMC one way or the other.. Both equities and rates should depend less on FOMC and more on intrinsic and unexpected events.

Talking of unexpected evens, the one is of course the US presidential election. The general expectation is a sell-off if Mr Trump wins. Although I fail to see a rally even if it is Mrs Clinton. And of course market expectation can be wrong. In 2012, it was widely expected that a Obama win will be bad for equities, and indeed there was minor sell-off leading up to the election day. However the results marked the start of a long stretch of bull run.

October was also a historic moment for Reserve bank of India. It was a new Governor (following the exit of Raghuram Rajan) and its first ever Monetary Policy Committee decision. And it was a decision quite difficult to understand - an (mostly) unexpected 25 bps cut. RBI revised GDP higher, and both real rate and inflation lower. A lower real rate expectation usually means a lower potential GDP. That means a higher GDP will lead to a potential overheating. A lower inflation rate is not consistent with this, unless RBI is expecting substantial imported disinflation.

India's decreasing credit growth is a worry, but it is not clear higher rates are the culprit here. The decline is driven mostly by the industrial sector - which presumably has more on its plate than to worry about higher rates. And in any case the pass through of RBI rate cuts by the banking sector has not been exemplary in recent time -which has been mired in its own significant bad loan problems. It was appeasing to the markets (and politics perhaps), but hard to imagine how much, if at all, it will help the economy forward.

Macro: The End of QE-topia

Negative rate is much more than what it says on the label. One of the cornerstones of modern finance is what is called present value (PV). PV is used to evaluate real projects, value financial investments or price derivatives, you name it. Surprisingly, based on my personal experience, it appears many practitioners and investors are unaware of the fundamental assumption on which this all encompassing concept of PV is delicately balanced - an assumption of a properly functional lending and borrowing market. Without that, there is no mean to transfer values across time back and forth, and PV loses its real meaning. Negative rates makes one question the validity of this assumption.

Central banks, it appears, are having a hard time. Last week's BoJ's underwhelming policy outcome was scorned off by the markets with an emphatic rally in Yen and sell-off in JGBs. This week BoE is widely expected to kick-in with some Brexit easing, and the markets so far has greeted the possibility with a renewed sell-off in FTSE 100. ECB is also expected to up the ante with another QE extension sometime later this year, and the European equities do not seem overjoyed about it. To contrast, S&P 500 seems pretty much nonchalant about a plausible Fed hike. The usual QE-led risk rally, it appears, are drawing to an end. In fact a few are already calling out for a regime change - from QE to deflation dominance (or lack of demand).

In the wake of the Great Financial Crisis, most central bank carried out a massive amount of monetary stimulus. One way to track the global monetary stimulus beyond policy rates is to track the combined balance sheet of major central banks¹, as we see below.

Few would argue against the unprecedented monetary stimulus led mostly by the Fed which served a crucial purpose during and after the crisis to restore confidence, liquidity and growth conditions. However, the effectiveness of QEs from other central banks have arguably been much weaker. ECB QE is so far hardly "successful".

Also, over time, the impact to real economy has grown visibly less dramatic. Below chart (left one) shows the growth in global major central bank balance sheet  vis-à-vis growth in M2 money supply as well as bank lending across major economies². Since the abatement of the European Sovereign Crisis in Q3 2012, all the measures have started moving in lock-step. What is more, the magnitude of global M2 growth has been lower than central bank balance sheet growth, meaning less bang for the QE bucks. The bank lending growth has been even lower than that. It is hardly a surprise we started to have quite a bit of noise around the effectiveness of QE and monetary stimulus around that time and since.

It is not hard to see why. As the right hand chart³ shows, irrespective of what the central banks have been doing, the global private sector still continues with deleveraging (with some exception, like US corporates). The excess savings - especially for Euro area (and a large contraction in dis-savings in the US as well) clearly underscores the problem. This arguably is an expected outcome of a balance sheet recession - wherein the private sector, afflicted with too much debt and in a process to repair their balance sheet, will try to increase savings and desist from borrowing no matter how low the lending rates are pushed down by QE. This is less a question about pricing and more about the capacity and willingness to borrow. On top, the increased regulatory burdens and negative interest rates certainly did not help the banking sector much to upsize their loan books. The combined effect - anemic global demand and as a result, stunted global investments (not helped by pre-crisis built-up over-capacity in certain sectors) - was given a new moniker, secular stagnation.

Economies can be stimulated using many forms and jargon. But in any case, to boost demand it must work to enable the demand side to afford it. And this increase demand must be paid for by either increased debt (i.e. borrowing) or equity (like increased transfer or wage). Monetary policy, in practice, mostly tend to fund this increased demand through debt in its standard transmission channel through banks. In a scenario where many are focused on reducing leverage, it is no surprise that this will have a less-than-expected impact. Monetary policy can enhanced equity based spending as well, like through wealth effect or inducing an increase in wage through increased inflation expectation. While this has worked in the US, for the rest of the world, especially in Euro Area and in Japan, this has hardly been the case. The dis-inflation remains very much alive.

There are some recent trends, however, that is slowly becoming a theme - and it involves the other side of the stimulus coin. 2015 has been the first year after the extra-ordinary time during the crisis, that major global economies have experienced a reversal of a combined fiscal tightening (see below⁴ on the left). We are past the fiascoes like sales tax hike in Japan and the excessive focus on balanced budget in Europe. And a few countries like Canada and Japan have already stated fiscal stimulus as their explicit policy tools. US may see similar moves after the election. Of course the downside of the government playing the role of "consumer of the last resort" is that this comes at a cost of debt concentration at government sector. 

We are on a cusp right now. Global consumption, despite all the allegation, has shown considerable resilience (although much away from their pre-crisis period, see chart⁵ above on the right). What we want now, more than ever, is avoiding any policy mistake. Given the fragile nature and very low margin of error on the policy side, it will be hard to recover from one. We are past the days of equity rallies with every new round of monetary easing. Markets will focus more and more on the underlying growth. This growth will of course have some costs - the key policy issue will be how to allocate that in a balanced manner between the fiscal and monetary side of this. One-sided efforts from central banks - increasingly larger asset purchase from a rather finite pool in a world characterized by negative interest rates and safe asset shortage - is perhaps past its used-by date.

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1. source: national central banks
2. source: national central banks, IMF, Bloomberg
3. source: national statistics offices, IMF
4. source: national statistics offices, national central banks
5. source: national statistics offices, Bloomberg

Macro | The Aerodynamics of Helicopter Money

As a former rotor-craft specialist I do have some experience with helicopters and its dynamics. It is a machine not supposed to fly, but somehow it does. And for some missions it is immensely more useful than the traditional stuff - fixed wing aircraft.

The next best thing to QE is already in town. Ever since former Fed chairman Ben Bernanke had a discussion with Japanese leaders last week, this has captured the attention of mainstream media. Although the BoJ Gov. Kuroda has effectively ruled out "helicopter money" (HM) on Monday, nobody missed the phrase "at this stage" in his statement. With increasing market frustration with the now-standard QEs, HM appears a real possibility in future policy adventure should things get much worse.

As is famously known, the term was originally described by the famous monetarist economics Milton Friedman to describe a permanent money creation and direct distribution to general population by central bank. In recent context, the meaning has changed more to monetary financing of fiscal stimulus. Nonetheless, it is interesting to see how this policy compares to other central bank tools like policy rates or QE.

There are two ways to look at, one from the accounting perspective and the other from economic perspective. From accounting point of view, HM is markedly different than other tools like policy rates or QEs that goes through what is known as open market operation (OMO). A central bank balance sheet, very roughly, can be thought as below. 

In traditional policy operation, the central bank announces a target rate and use standard OMO to adjust the level of treasury holding (asset side) to affect corresponding changes in commercial bank reserves (liability side). Tight monetary policy reduces the available reserves and hence put pressure on the fed fund rate (the rate at which commercial banks lend reserves to each other). QE in operation is similar to this, only the central bank buys a much larger quantity (and longer maturity) of treasuries (with a corresponding large increase in bank reserves). While the operations are similar, the channels through which they impact the economy are quite different. In case of regular OMO, the channel is mostly interest rate channel, where the long term interest rates are assumed to be affected by short term rates. In case of QE however, there are multiple channels, with the most important ones being inflation expectation, interest rate (portfolio re-balancing) and wealth effect. See here for a more detailed view.

HM is quite different than either of these. In the original scenario propose by Milton Friedman, the central bank simply prints money and distributes to the public. From accounting angle, this means an increase in currency in circulation (liability). It is clear the only change that can balance this is a corresponding decrease in capital of the central bank. Technically a central bank can run a negative capital indefinitely, as it can print money to fund it. However, in practice this may be limited due to legal rules (if any) and public and political perception among other things.

The current avatar of HM is different. The proposed method is government issuing perpetual zero coupon bond (appearing on the asset side of the central bank against a balancing liability entry for government account) and then using the proceeds to fund tax cuts or pay for infrastructure programs (ultimately money in government account from the last step disappearing in to accumulating commercial bank reserves). Prima facie the net effect has the appearance of a QE process as outlined above (treasury holding goes up, reserves goes up), But the dynamics is quite different. In QE, the money created will hit the commercial bank reserves directly. Now it is up to the lending intention of the commercial banks (and of course the ability and willingness of the general public to borrow) if this will just sit at the reserve or will actually enter the real economy. However, for HM, it is the other way around. The money created first goes to (via government) the general public and finds its way back to the banking system and reserves as the public either spend or save it. In this sense this monetary financing of fiscal expenditure is closer to the original HM concept in spirit.

The key difference is that QE or other OMOs are essentially asset swaps, swapping treasury for bank reserves - a swap between the two sides of the balance sheet. While HM is essentially swapping central bank capital for base money (currencies in circulation or bank reserves). In the above example, technically we recognized the zero coupon perpetual bonds issued by the government on the asset side at acquisition cost. But clearly such a bond has zero value, and a fair value treatment will create a hole in the capital, exactly like the original HM. The other key point to observe is that while QE is an increase of monetary base, its permanence is a function of central bank's credibility. Some may legitimately believe the central bank will withdraw this (sell QE assets) once the situation normalizes and hence factor that in into today's decision. However, HM is fundamentally an irrevocable permanent increase in base money. There is no way to reverse it unless central bank destroys currencies in circulation (reverse HM?) or forces the government to redeem those zero coupon perpetual bonds. Both seems highly unlikely under most scenarios conceivable.

Now on the impact of this policy on the broader economy - well since economics is not an exact science (and many assumptions are not even falsifiable), you can pretty much successfully argue for whatever you believe in. An HM operation can cause the interest rates to go down, as this means a large money supply in the economy. It can make things even worse if more people choose to save the money they get than to spend it, fearing an even lower interest rate and trying to keep interest income constant (think of retirees). You can argue for an increase in interest rates as well, as an injection of money in such a manner may increase inflation expectation. You can postulate that HM will cause GDP to increase - as a result of the direct fiscal expenditure and also through the fiscal multiplier. Or you can invoke the crowding out (and with some labor even the Ricardian equivalence) to assume no change at all.You can follow the thread of a heated argument here. However to give some method to the madness, we can arrange our thoughts in the IS-MP framework.

HM can be explained in this framework (see the figure below). The story is, in the beginning the aggregate demand is such that the output (GDP) is at y, below natural rate (y*). This causes inflation to fall. The central bank responds with a rate cut, to reduce the real rate, and pushes MP to right (expansionary policy), but hit the nominal zero lower bound. Then HM comes along and jacks up the inflation expectation (assuming that is the dominant dynamics, see above). This pushes the MP curve further to the right to MP1, beyond the possibility of zero lower bound. Then the fiscal stimulus component kicks in and moves the IS to the right at IS1 as well, bringing the output back to potential level of y*. Note the model suggests a final (real) interest rate levels higher than a pure play monetary policy response (only MP shifting to the right).

Theories apart, from market perspective a few things are more certain than others. Firstly, unless there is a crisis of confidence (or potential), fiscal stimulus is usually good for an economy, especially so at a zero rates environment when traditional monetary policy faces serious constraints, and at a time when economy can do with a booster dose or two. The fiscal stimulus component of HM therefore should be positive for markets and economy. One can argue why monetary financing is necessary when the government can borrow at such low rates. This is an excellent argument which the BoJ governor seems to like, at least for the time being. Nonetheless this part is positive for equities and risk assets. For FX markets, note the possibility of both the rates going down and up as noted earlier. Interestingly, this affects different parts of the curve differently. The part that will tend to go down will be short dated rates and long end will tend to push up. As a result FX (which is mostly influenced by the shorter end of the curve) will go down. And as for rates, assuming the market perception of HM is positive, this will mean 1) a re-pricing of the terminal rate upward as well as 2) increase in inflation expectation pricing. This will mean a bear steepening of the curve (increase in rates led by the long end on the balance).

The other aspect is of course the political risks of monetary finance. Some central banks absolutely abhor monetary financing (Bundesbank!), and many are potentially legally unable to do so. But leaving aside the muddled politics and economics, the key takeaway here is that in case of the next Lehman Brother scenario or a China bust, this talk about HM should assuage investors' collective concern that central banks are running out of options.

Macro: FOMC Dot Plots, The Secular Stagnation Illusion

One of the major surprises in the March FOMC meeting was the re-marking of the long term rates as expressed by the Fed dot plot.

While most speculators were cutting their short bets on the 10-year treasury (as per CFTC commitment of traders reports) and were actively going bullish on the long-end, the short end short positioning was mostly maintained. This was especially supported by the up-tick in the inflation data in core and headlines before the FOMC (as well as inflation now-casting from the Cleveland Fed).

There are conspiracy theories about the Fed's worry and motivation for a weaker dollars in response to the bold liquidity enhancement actions from other major central banks. However, if we really take a deeper look in to it, a different story emerges⁽¹⁾.

FOMC started publishing the dot plot in 2012, between the QE2 and the QE3 phase. Looking at the evolution of the dot plot implied fed fund term structure, there have been two major changes since. First one happened just before the start of the QE tapering. That was the beginning of a steady upward shift for the fed funds rate in the near horizon (~3 year), where they stabilized. The second set of changes came in later half of 2014, which resulted in another gradual move. This time it was a downward shift of the long term rate forecast. From the peak of 2014, the FOMC estimate of long term fed fund rate is down by 75 bps. (Note I have projected the long term rates from the dot plots to 5-year maturity bucket.) Some suggests the Fed is slowly embracing the secular stagnation theory.

There are certain amount of merit in that hypothesis. The current projection implies, assuming Fed's target inflation of 2 percent is realized, a long run real rate of 1.25 percent. And irrespective of your view on the r-g model, a lower r does signify a lower level of long run real GDP growth. For the balanced case of r=g, this implies a growth rate of 1.25 percent.

This seems pretty pessimistic from the recent trends in real GDP. Figure⁽²⁾ below shows the trend in real GDP (normalized at 100 at the beginning).  The post crisis slope (since 2013) is definitely flatter than early 2000, but not by a huge margin (except Euro area). Add expected inflation to this numbers to get the long run nominal rates. Depending upon your preferred choice (10-year and 5-year swap market breakevens at 1.8 and 1.6 percent respectively, 5y5y TIPS breakeven at 1.66), this seems to imply a long-run rate in the range of 4.1 to 4.3 percent. Almost a full percentage point above FOMC dot plot.
The market seems to be even more pessimistic. The chart⁽³⁾ shows the spread of 1 month USD Libor (implied from the euro-dollar futures and swap curves) vs the FOMC dot plot. The 2013 taper tantrum was the only time when the market got spooked with a rate hike and over-estimated the future path of rates. Since then, it has steadily become more and more pessimistic to the FOMC prediction. The largest disagreement is in 3 years and beyond.
This level of suppressed nominal rates means either the market is pricing a marked departure in the growth trend from what we have seen even post-crisis so far. Alternatively it means a near term recession and/ or more liquidity measures from the central bank. Or at least it is pricing in the Fed's inability to hike rates substantially given the situation in China and Europe and Japan. So far the Fed has been doing the catch-up to the markets pricing.

The first possibility is what secular stagnation is all about. So far most of the evidences have been important and potentially even supportive, but at the same time inconclusive. It is not certain the impact attributed to secular stagnation is really a not cyclical effect attributed to a long run structural change. In fact Larry Summers, who revived this idea of secular stagnation in 2013, is himself very much aware of this. See the disclaimer in the last paragraph here. There has been many different views on this, for example see here for the counter-view from former Fed Chairman Bernanke. Real-time economics is hard. It will be much easier to settle this debate after a decade or two. But right now, I think the biggest argument against secular stagnation is the prior probabilities. The long run world growth rate data (for example see here) shows a staggered improvement, with last great bottom around just before the Industrial Revolution.  All recent variation in world GDP since post war seems more or less cyclical phenomenon in this scale.

And the other possibilities to justify such depressed nominal rates are definitely cyclical. In fact the FOMC statement and general stance so far, downplaying secular stagnation and emphasizing inflation, clearly shows the Fed is eager to keep its options open. Secular stagnation is a rather long-term commitment to a particular view around equilibrium rates, GDP and inflation. It does not come handy to set appropriate monetary policy expectation and maintain credibility at the same time in real-time economics.

And in that scenario, near to medium term growth and inflation outlooks are much more critical. This also means a higher volatility and data dependency as the markets as well as the Fed react to data. The recent inflation uptick has been feeble, but definite. The fear of Yuan devaluation has subsided significantly. Given Fed's stance, it is perilous to believe the only move for the long term rate for the dot plots are down.

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(1) data from Federal Reserve
(2) data from BEA, Office for National Statistics, Eurostat
(3) data from Federal Reserve, Bloomberg

Macro: ECB - Rock and A Hard Place

ECB is widely expected to launch another round of monetary easing in the policy meeting this Thursday.

The chart below amply captures the apparent reason for an increased market expectation and willingness on the part of the central bank for further monetary stimulus. Both the general inflation (HICP here) and wage inflation (unit labor cost) levels are on a steady, relentless downward path.

However, notwithstanding the limitations of negative rates regime and QE, the moot question is how effective another round of monetary policy easing will be.

The contraction in Euro area credit growth since the financial crisis is still to see any sustained correction. And very lately it seems has turned another corner to unwind all the recovery made during last couple of years.

to dig deeper, we take a quick look at the ECB bank lending survey, that specifically probes the problems around demand and supply.

The survey shows a significant recovery in credit demand - both in terms of back-ward looking data and forward looking expectation. Similarly, the credit condition is comparable to the good days before the financial crisis

Going by these surveys, it appears neither credit tightening or potential demand is a problem right now. The relaxing of credit condition gradually started improving after the euro area sovereign crisis was averted, and now has settled down around the levels of best years during the pre-crisis era. The demand side started recovering a bit late, but nonetheless does not seems very off from the pre-crisis levels.

And this is no way a limited result. Even, the SAFE (Survey on the Access to Finance of Enterprises, latest April to September 2015) survey reports clearly notes:

"Euro area SMEs considered access to finance to be the least important problem that they faced (11% of respondents, unchanged from the previous round), although results differ across countries. Instead, finding customers remains their main concern (25% of respondents, down from 26% in the previous round)."

So what is the problem. Let's again look at the second chart again vis-à-vis US credit growth (technically it is not exactly apple to apple, as the US series is Bank Credit of All Commercial Banks from the FRED database, not just to resident non-government sectors). See the co-movement before the crisis and the decoupling after.

It seems a bit puzzling to say the least. The credit supply is definitely not under threat from credit standard tightening (i.e. no significant financial or liquidity stress). Nor the demand shows a particular hole in that area, at least according the surveys. Nonetheless the credit growth is dismal.

There can be many reasons. A recent note on the excellent IMF Blog hints at one - this probably can be a bank balance sheet and capital rules issue than a financial stress or liquidity story. And given the surveys, it seems the latent demand seems to be still around (note the contradiction of the SAFE survey and bank lending survey on the outlook on demand).

To me, it seems a further increase in liquidity or a reduction in rates will be just another round of insignificant attempt to correct the situation. The only effective monetary policy is perhaps an inflation expectation shock - and QE  (at least in its current avatar) is no shock anymore.

And on this front, what can really achieve a lot more bang for its buck is fiscal stimulus. Given the extraordinary economic situation, it is indeed surprising to see the tightness in fiscal situation is rivaling the pre-crisis period. But then again, unlike Canada, with average government debt of 90%+ of GDP, it is hard to push fiscal stimulus politically, even with the best of intention and economic clarity.

The most likely path for Euro area is to follow incremental monetary stimulus and hope for a global return of inflation, quick enough to avoid a general deflationary mind-set taking its root and a permanent damage to the potential output. Only a crisis can change things.

Macro: Quantitative Tightening - Revisited

Here is a fresh look on the topic from the excellent sober look blog. It also refers to a post on this blog back from September last year.

The sober look piece presents some insightful charts and raises questions that needs further re-look. One thing to add here on the top of my head - it has been alleged that petro-dollar sovereign wealth funds have been selling more of equities, sparking a flight to safety move towards the US Treasuries.

Quite the opposite what many market analysts expected.

ECB Action: The Jedi Tricks Still in Store

So ECB is almost "pre-committed" on some action in the March meeting with all the talks going on. If you are not convinced, remember how Mr. Draghi went out of turn in the last press meeting in January, to remind everyone that the decision to "consider" action in March was an "unanimous".

 

Since then the stock markets sold off a lot, break-even inflation went downhill (although Euro are inflation was not that much disappointing) and BoJ announced negative interest rate policy, first time in its (rather long) history of monetary stimulus.

 

But in spite of all these actions and promises from central banks, the response to monetary stimulus is already waning. The equity markets unwound the second round of monetary stimulus from BoJ in months, and the latest round in days in fact. And even with such a strong promise for action from ECB and relatively dovish Fed, you would have made money if you shorted euro rates vs. USD.

 

The question is what else the central banks are left with. Well, I think it is too early to say they are out of options.

 

Firstly we still have quantitative easing. It may have some limited effect on markets already under pressure from such measures, like Japan or Euro area, but in places like the US or the UK it is still very much potent. [EDIT] Even in case of the others, QE can still be very impactful, at least on the markets, in case the underlying assets are extended to other asset classes - like bank stocks!

 

Then the negative interest rates. This is the one I like the least. Firstly it is NOT very clear what it exactly does for the "general level of rates" in the economy. If everyone is super-rational and able to free his or her mind from this weird concept of having to pay to park cash, life can goes on as usual. But that is a lot to ask. Firstly the banks cannot pass on negative interest rates to customers effectively. This harm the banking sector profit in a big way, as we have seen in the large re-rating of banks across markets recently. Plus if your economy is dependent on banking sector lending (as opposed to direct capital market access) this can be a dangerous move. Facing negative interest rates, banks have incentives to either improve bottom line by cutting costs, or reduce lending business altogether - focusing on either best of their clients and/ or riskiest names. This is not bad for big corporates. This is not bad either for riskiest customers. But this is bad for the ones sitting in the middle, which is the vast majority of the small and medium sized business. Besides, negative interest rates are politically unpalatable, especially in election years.

 

Then we have the yet un-tested weapon: the ultimate Jedi mind-trick - enhancing the inflation target. The trouble is there is no fast mover yet. And it is hard to be experimental with this unless one is forced to. A bad move can displace the inflation credibility that most central banks fought hard to achieve.

 

I think how the central bankers will react will depend on the nature of problem they are reacting to. A minor risk-off or continued commodities sell-offs will most probably elicit a (now) conventional reaction of QE or increasing NIM. But a only a real full blown crisis will bring in the inflation retargeting (along with host of other measures presumably).

 

And given the specifics of the various institutions and home politics, I would bet in such a full blown crisis - the governor of the Bank of England is the most likely candidate to take the first step. And ECB will likely be the last.

 

Wave the hand and say inflation should be 4%, and leave the rest to the Midi-chlorians.

 

So if you are an investors from EU area looking for a tail risk protection, a relatively cheap hedge is paying 5s30s in GBP vs. the Euro are. And most likely this will be Brexit proof. If indeed we have such an outcome, probably a selling of the long end of curve by non-UK investors will lead to a steepening of the GBP curve.

 

The spread has tightened recently but still near recent lows.

 

 

 

 

Ubernomics: NYC Edition

I have no idea how good or bad economic forecasts based on general chit chat with taxi-drivers are.

But according to my sizable (and arguably non-random) sample of Uber drivers in NYC over last week, the economy this January is definitely doing worse than January 2015. One of them however, helpfully pointed out that the looming election is to be blamed!

Somehow that coincided with today's data releases - both the personal spending and PMIs. Food for thought.

Five things I do not believe in...

But have no evidence to the contrary. Yet.

1. That the dealers are running zero corporate bond inventories
2. That China shorts is going to make money for investors (UPDATE: At least not in macro shorts. Possibly in selective equity shorts. There seems to be a fissure within the old and the new economy in China)
3. That the next crisis (whenever that happens) will mean a dollar rally (against euro) (UPDATE: See this, although I think it misses the point. It is about in what currencies global assets and liabilities are funded)
4. That migration crisis is just another one for Europe
5. That we have reached the peak Geo-political crisis (think about power balance in post-oil scarcity world)

Inflation Puzzle: Back In Time

"Inflation typically rises during an economic expansion, peaks slightly after the onset of recession, and then continues to decline through the first year or two of recovery. During the present U.S. expansion, however, inflation has taken a markedly different path. Although more than six years have passed since ____, inflation in the core CPI (the consumer price index excluding its volatile food and energy components) has yet to accelerate."

Guess the missing time line in the above paragraph. It is from a paper from NY Fed, dated 1997. It refers to the 1990-91 recession. But it could easily apply to the 2008 GFC. With the benefit of hindsight, it is now questionable if the Fed should have been more hawkish during the 90s and 2000s to avoid the great financial meltdown. But in 1997, with all fairness, there was little support for more hawkishness in data.

A recent Bloomberg article talks about six million reasons for Yellen to think before raising rates. But I wonder if we will ever have those kind of jobs back in listing which the 60 somethings like Mr Elanko are skilled for. 20 somethings are working overtime and designing apps against Miss Yellen.

In a case of structural unemployment, the numbers matter less than the rate of increase in wage and employment cost. The Fed knows it. So for me, a December pause is more worrying than a hike.

Inflation: Think Global (In Chart)

A few observation on inflation from a global perspective

#1: Global inflation has been weak, but core has been steady. Here the global data points (like headline or core inflation) are calculated using the GDP weighted national measures of the top 20 countries in terms of GDP in current dollars (representing 79.9% of world GDP. Pareto!!).

The difference between the core measure and the headline is even more important as the wedge between them is currently driven mostly by a single factor - energy prices. The concept of inflation is an overall price rise. A change in a particular component is mostly a relative price change, not an overall price change. Central banks have little controls over production of individual goods and services. If there is a large relative price rise for doughnuts for some reason, a hike in policy rates most probably is not going to help it (unless this relative price rise permeates through the economy and finally in wage expectation through second round effect).

#2: The smack-down of inflation in commodity exporting countries is most prominent for the ones with fixed exchange rate regimes. With a few exceptions, most of the metal and energy exporters are not suffering any great dis-inflationary pressure in core measures otherwise.

#3: In terms of professional forecasts, inflation expectation remains steady, but the market based measures for the US are not so. 

#4: The consumer demand is weak. Especially if we measure in dollar terms. We have a scenario of low rates, a strong dollar, very weak commodity prices and weak global demand. Commodity prices respond a lot to investments expenditure globally. However, the consumption expenditure has been a relatively stable component of economies across countries and time historically. Since mid of last year the consumption expenditure globally in dollar term has been in a strong contraction phase, approx 6% from peak till Q2 2015. This is only matched by an approx 8% drop during the GFC. And this is not driven by US or China much, rather rest of the world, including Euro area and Japan. It is hard to say if this has bottomed out and we will see the savings from drop in energy prices being channelized to recover consumer demand. 

Nonetheless, the possibility of a wage driven inflationary pressure cannot be dismissed. The chart on the left shows scatter plot of job opening rate (JOLT), Employment Cost Index and PCE core inflation against headline unemployment rate on x-axis, since 1980. The starting points are marked in red and end points in green. As we see in case of job opening, there has been some significant hysterisis (unemployment rate higher, given the job opening, if we measure the slope from the earlier part of the curve). This may points to a case of structural problem in unemployment. That will put forth a case against a downward revision of Fed's unemployment target (NAIRU). On the other hand the wage inflation (here ECI) and broader inflation (PCE) still shows inverse relationship. The Phillips curve is still alive (esp. for wage inflation), although flatter in recent times. Given the fact that Fed action has always a lag before it affects the real economy, this will keep the case for a early hike on the table.

#5: And related to above point of global consumption, the global imbalance in excess savings seem to be heading towards a forced reduction. The left chart shows excess savings (or equivalently current account balance) in nominal dollar terms. As we can see the large CA deficit of US has historically been balanced by large surplus of Japan and lately China. The EM had a spike just after the late 90s Asian Crisis. But that is mostly negated now. The recent cause of concern (Euro Glut) was a large and ballooning surplus of Euro Area. With the fall in oil prices, the Petrodollar balance is now going the other way to counter it. These low commodity prices may play a crucial role in re-balancing the flow of trades and capital across the globe. ( it is evident from the chart that trade volume has come down significantly.) It is not clear to what extent this balancing act will help consumption and through what channel, but it is definitely better than exploding imbalances in the medium to long term.

Also since the financial crisis, after the very initial period, it has been mostly a battle fought by central bankers, with fiscal stimulus sitting mostly on the sideline. In fact the withdrawal of high fiscal stimulus just after the collapse might as well have countered central bank efforts. We are politically getting in a better position to consider and use fiscal stimulus than the height of European Crisis and talks of austerity. The global budget balance is in fact back to the pre-crisis average level. And if the economy is not, there is a good reason and scope for fiscal stimulus in coming years.

The key takeaways: Despite the weak global demands and large savings imbalance (which are related), there is a case that the commodity prices has done some corrections, and a persistent weak demand/ high global excess savings may not be realized. And we still have the upside of fiscal stimulus in case consumer demand needed a booster does. At a global level, most measures of core inflation, and non-market based inflation expectation remains robust. However, the market seems to be pricing a very pessimistic outlook for inflation globally. And also as mentioned earlier the inflation skew pricings are improving on the upside surprise.

Is this a case of peak (dis-)inflation worries and significant consolidation and upside from here. Hard to be sure, but I would say chances are good than they were before. Of course inflation can go either way from here, but in most scenarios they have a better chance of ending up higher than current levels. And a reasonable dollar weakness from here can tilt the balance in its favor further.

Trades

1) In case Fed is on time (which we will only know with the benefit of hind sight): long inflation upside and nominal rates sell-off with short dollar for cheapening.

2) In case Fed is delayed: long vol - a sharper rate of hike will catch many unsuspecting asset classes on the wrong foot.

Economics: The Myth of "Quantitative Tightening"

It is the latest populist theory doing the rounds in the financial media. Even the mainstream media is now flooded with this now. See here and here

To see why it does not make much sense, we need to understand what quantitative easing actually is, in terms of Economic models.

The standard Keynesian model is the famous IS-LM model. This captures the goods and money markets equilibrium simultaneously in an economy. The IS curve of the model, derived from the equilibrium of output and aggregate demand, captures the goods market equilibrium. It outlines the combinations of interest rates and economic output for which such equilibrium is possible. It is a downward sloping curve, as for a given level of external factors, a higher interest reduces the investment spending and hence output. The second part of the model is the LM curve. Derived from the demand of money, it captures the combination of interest rates and output for which the money market is in equilibrium. This is an upward sloping curve, as for a given amount of money stock, the demand for money goes up with higher income and lower interest. For more on this look here for a quick introduction. The entire economy is at equilibrium at the intersection of these two curves, which implies simultaneous equilibrium in goods and money markets.

However, I think to analyze QE, it is better to switch from IS-LM model to IS-MP. It is a variation of the IS-LM model which retains the same IS curve, but replaces the LM curve, by an MP curve (MP stands for Monetary Policy). The advantage is primarily two-folds. Firstly, unlike the implicit assumption in IS-LM model, most modern central banks do not target money stock, but rather a policy rate - which is explicit in the MP model. Secondly, the IS-LM is a bit ambiguous. Ideally the relevant interest rates for IS curve is the real interest rate, and nominal interest rates for the LM curve. So effectively it is a bit round-about to incorporate inflation directly in IS-LM. And as we will see QE is largely about (expected) inflation. For more details on IS-MP, look here (opens PDF and a bit wonkish)

Figure below shows a typical IS-MP curve. As mentioned before, the IS remains as it is. The MP is upward sloping. Which makes sense as most central banks uses a Taylor Rule approach to determine the appropriate level of real rate to target, balancing output and inflation. For a central bank targeting purely a real rate (i.e. inflation targeting), the MP curve will be horizontal.

In the IS-MP model, the economic shocks can be analyzed in a manner very similar to the IS-LM model. Suppose the economy is initially at equilibrium E0 with output at potential output of y0. If there is an external negative shock to aggregate demand (like the 2008 crisis), the IS curve shifts to the left (IS' in the plot), along with a drop in output y1 (which is below the potential output) at a new equilibrium of E1. The response of the monetary authority is to shift the MP curve towards right sufficiently (expansionary policy) so that the equilibrium point E1 shifts to E2, which brings the output back to potential, but at a lower real rate (r'). How the shifting of MP to right is actually achieved depends on many things. For a normal economy with sufficiently high nominal interest rates and stable inflation expectation, manipulating the nominal rate (setting fed funds etc) can achieve it. In case of a positive shock the dynamics works in the reverse. This is what central banks do in a nutshell.

The question is what happens if the nominal rates are not high enough (the so called liquidity trap). Or the initial shock is so large that to change real rate enough to reach the equilibrium E2, the nominal interest rate has to become negative (with a given inflation expectation). Obviously, this is not likely to work. Here the interest rate implies the general level of rates. Forcing the general level of nominal rates to negative territory is quite a challenge (if desirable at all), as people can just hold cash instead of bank deposits (thus avoiding negative interest rates, i.e. paying fees to park cash at banks).

The way out is to tweak the other component of the real rate. That is inflation expectation. If the demand is lower than potential, the inflation and inflation expectation has already started creeping towards a lower base. If the central bank can convince people that it is not going to stay low for long, and jack up the expectation, that can reduce the real rate, even at a zero nominal bound. Which in turn spark real activities. Quantitative easing is a tool to achieve just that. In fact we can express real interest rates as below (as a matter of definition):

Long term real rates = average path over expected future nominal rates + term premium - expected inflation.

Even at zero lower bound, the central banks can use tools to manipulate any of the three terms to achieve its objective. For example, the "forward guidance", adopted by Fed, is a tool to manipulate the first term. General asset purchase influence the second term. And depending on how the QE is planned and communicated it can influence the inflation expectation. In fact the standard way how QE works is mainly two channels - a) the portfolio re-balancing channel, which compresses the term premium, and b) the inflation expectation channel. And together they can work exactly like the expansionary monetary policy in the diagram above. Even at the zero nominal bound. That is pretty much what quantitative easing is. So by definition, "Quantitative Tightening" will work in reverse. 

But, we are not talking about quantitative tightening by the domestic central bank here (i.e. the Fed), but rather foreign central banks. To analyze that, we need to extend out model to an open economy.

Much of the things remain the same. The stuffs that change are two-folds. Firstly, the IS curve is now influenced by the real exchange rate (opens PDF, a brief primer). An appreciation of dollar in real term will make imports attractive for domestic consumers and export costly for overseas consumers. So this works like a negative shock to the IS curve (domestic output), a shift to the left. Secondly, we also need to incorporate the foreign exchange market equilibrium, captured in the line BP (abbreviation for Balance of Payment). This equates the demand for foreign exchange (import over export) and supply (net FX inflows, ignoring central bank reserve changes, which is only applicable for pegged currencies or managed floats). For perfect capital mobility, this will be a horizontal line, as we can have only one interest rate at which we can have equilibrium. At every other rate, large inflows or outflows will overwhelm and restore balance. For general capital mobility, we have an upward sloping curve. The equilibrium for an open economy is achieved in the intersection of all three curves - IS, LM and BP

In such a scenario, negative demand shock can be countered as before. Assuming a floating exchange rate regime, an expansionary monetary policy, reducing fed fund target or QE as the case may be, pushes the MP curve towards the right to MP'. Given the lower rates, the new point is below the BP curve, which implies an imbalance in the FX markets. In this case, the dollar becomes cheaper in real terms, leading to simultaneous increase in net export (IS shifts right to IS') as well as improvement in current account (BP shifts right to BP'). This changes the output from y0 to y1 at a lower interest rate levels. The equilibrium changes from E0 to E2. Notice the change in real interest rate is less than the previous case. A tightening works in the reverse.

Now "Quantitative Tightening" by PBoC or other central banks, (i.e. selling of treasuries) is a totally different beast. PBoC has NOT decided overnight that it is the monetary authority for United States, and is NOT trying INDEPENDENTLY to influence the monetary policy for dollars. Nor it can change the total dollar money stocks. It is selling treasury because of its own monetary policy aim, which is to maintain the Yuan trading range.

So in effect, in the above diagram, nothing changes. No dollar monetary base, nor real exchange rate, nor inflation expectation to move any of the curves. There is a potential of changing the term premium. But assuming it is selling foreign reserves for the purpose of exchange rate targeting, it must be selling not only treasury but all other reserve currencies as well. That means it will require a huge selling by PBoC to achieve a modest increase in the term premium. Which is unlikely. 

Also a QE or reverse for a large bond markets like US treasury (approx USD 16 trillion outstanding) primarily works through inflation expectation than portfolio re-balancing channel. For example, the episodes of previous QEs by the Fed actually saw a modest increase in treasury yields, but an overall reduction in real yields (as computed through breakevens). In addition, the Chinese FX reserve can be around USD 3.6 trillions on paper, but given the size of the economy and exports and imports, China must maintain a part of it as a safe guard as per IMF recommendation (opens PDF). So effectively a much less amount is available for this so called Quantitative Tightening.

And lastly, the entire point of treasury selling of China is maintaining the FX policy. The recent capital outflows increased the devaluation pressure on China, and PBoC is selling dollars and buying Yuan to protect the range. So effectively it is keeping Yuan artificially overvalued, one can argue. And that means, if they do not do that, i.e. stops selling treasuries, that will actually have an worsening impact on the US, as USD real exchange rate appreciates and shifts the IS curve towards left.

Now enough of theories. Let's look at some hard data. How much net selling is happening anyways in treasuries - based on TIC data as of end of June 2015.

Hardly anything that suggests "Quantitative Tightening"!

Although official ownership of long term treasuries has gone down, this is more than compensated by increase in private ownership. The only countries where we have seen total treasury ownership going down is Japan and the Switzerland + Benelux block. And on overall basis foreign ownership of treasuries is on a steady upward path, after a sizable reduction for a brief period of Taper Tantrum back in 2013.

Only Fed can do a real quantitative tightening. "Quantitative Tightening" by PBoC is mostly a nonsense.

Nevertheless, what is interesting in this entire model thingy is the dynamics. You might have noticed how the entire thing works. Any monetary policy changes in response to a negative shock in demand lowers the real rate. Similarly a positive demand shock will increase the real rate for the same potential output. Interestingly in recent times, the demand shock distribution has been highly negatively skewed (you can have a look at the real GDP distribution since 80). It is hardly a surprise ever since we have a constant downward drifts in general rates levels. Forget about secular stagnation and other interesting theories. Even in a perfectly normal economy, a negatively skewed demand shock distribution, along with Keynesian central bank, implies rates will have a tendency to drift down and eventually hit the zero lower bound and get stuck there. There are only two ways out. Either reigniting the animal spirits and optimisms of the industrial revolutions or the post-war period. Or a higher inflation target. Else downward yields are far more likely than a sharp sell-off in rates. No matter which foreign central banks are re-adjusting their FX reserve.