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

ECB Meeting: Front Running

There are expectation in certain quarters of further actions from ECB next week. While this is possible, I think it is not likely. The question is less about whether they "should" and more about if they will. ECB historically never did strong actions back to back, based on their premise that it needs time to see the effect of the last action. A back to back action in current situation might as well signify a certain amount of crisis perception at the ECB. In retrospect we will be wiser if indeed we are in a crisis or not, but it is highly unlikely the ECB will be willing to send out any such message yet.

 

The opening of the year has seen some wild actions across markets. However the underlying macro stories remains more or less the same, although admittedly towards the downside. The US is holding up strong on employment. The inflation weakness, when looked at the US only is reminiscent of the recovery from early 90s recession. On the GDP side there has been considerable revision (for example Atlanta Fed GDP now is considerably revised downward, so are the PMIs). Euro area itself has also undergone GDP downward revision, but the PMI has been quite strong and steady. Nevertheless the inflation expectation has remain stubbornly low. And China has hogged the headline in recent times, but that is arguably more because of policymakers actions than data surprise. The capital outflows continue and the economy remains in a need for rebalancing. In fact most of the Chinese Economic Surprise index ticked upward in recent times (see for example Citi Economic Index).

 

But nonetheless, the markets have been really shaky, especially in equities. The chart below shows volatility skews implied from index options across markets. They shows a strong return of fear (although much less than last August). Note the right hand chart plots the ratio of average skew to average absolute deviations, a measure of average fear as implied from the options market.

 

 

The technicals and price actions may well be in the bear zone, and probably we are poised for further corrections from here. For some markets, the January move is reminiscent of what happened in 2008 in January and then what followed. But however there are reasons not to worry about a large crisis like crash in risk assets. For one, we see no evidence of mass euphoria in equities as we saw in case of both early 2000s and also in 2008 among retail investors (left chart below), and speculative position is far more cautious.

 

Also, this is confirmed by flow data from ICI. The equities flows have turned a new negative early last year, after the high yield lost its charm in 2014. Lately even fixed income has seen a turn in the sustained positive flows. Similar flows can be observed for emerging markets funds. This is definitely risk averse positioning rotating in to presumably more cash.

 

Given this back-drop, it is less likely to have some fresh actions this meeting from the ECB. On that front, the expectation is further depo cut and/ or increase in QE. We already have some political misgivings on this, so any action perhaps have to wait. Euro rates are so low it is difficult to push it significantly lower - compare the reaction of the 2014 QE expansion from BoJ, where the initial reaction of around 20bps in 10y rate was unwound in the space of a few months. On top, given the political situation, sudden sell-off is perhaps equally likely and but with better risk-reward outcome. In fact the top risks in Europe is not disinflation. That is pretty much global (and will be more so if Chinese deflation export increases following sustained CNY devaluation). The top risk is the refugee crisis which has distorted the focus on integration of Euro area as a whole. On top we have un-resolved Spanish situation, and the distant, but no less real, possibility of Brexit. The underlying theme of global rate convergence cannot be indefinitely put off by outperformance of the US economy! When Japan had the so called "lost decade", it was pretty much alone (apart from, may be, an internal unraveling of the erstwhile Soviet Republic).

 

Technically, long term technicals on USD rates suggests most rates are range bound, with last bearish signals around 2014 to 2015, the long end being the last to be fired. On the slopes, 2s5s is poised for a steepening quite strongly unless there is a change in the macro story. So is the 5s10s30s fly.

 

long term technicals on EUR rates are similar to USD, most rates are range bound, but has a smaller tendency to revert back. Also most slopes are near the higher area of trading range, especially 10s30s and also 5s10s. Sterling rates signals are mostly bland with few long term signs.

 

On shorter term, USD Rates long end shows a poise for comeback from recent rally and a strong steepening in 2s5s. Euro rates has weak signals of an impending sell-off in 30y and also in 5s10s30s fly (belly sell-off). Sterling rates shows some poise for a steepening in the front end (2s5s area) as well, along with a flattening of the 5s30s and 10s30s

 

Cross markets technicals supports the story of USD slopes steepening vs. Euro slopes.

 

Trades here:

 

1. USD steepening 5s30s outright or conditional (EDIT: vs. EUR, changed from 2s5s to 5s30s for leverage on 1st Feb)
2. BP Box of 2s5s10s30s (2s5s steepening vs. 10s30s flattening)
3. USD EUR long term rates convergence in limited size.

 

EUR/USD will most probably remain range-bound. Any large move without any action to fade.

 

In many ways, the current global situation looks like the long recovery in the 1990s (see here for example). We had a similar balance sheet crisis of sorts, and late in the recovery we had Russia and Asian Crisis doing the China now. That signified the bottom of a bust in commodities then. After that, a frenzy of dotcom stocks and a boom in globalization and commodities ended up in a sustained rally in risk assets. Although we have arguably a technically focused start up frenzy around now, they are mostly outside the scope of the general equities market (see the over-exposure to manufacturing in equity indices, compared to the economy from a recent Goldman reports). And the commodities are doing the reverse this time.

 

Macro: From Peak Oil to Trough Oil?

How low we can go from here

Well here are two completely opposite perspective - to $20 (surplus argument) or to above $100 (geopolitical argument). The first one is standard, the second is kinda fat-tail argument (it can happen, but it is less like a probability and more like an uncertainty. Difficult to trade on). Then of course you have the click-bait articles like this and a long term official version of $80. Opinions apart, let's try to get a perspective from the available data. Here is a chart that juxtaposes the current built up inventory vs the marginal supply curve against price.

The inventory is indeed large (left chart). OECD inventory is 60+ days of consumption against IEA recommendation of 30 days stockpile. OECD estimates are mostly reasonable (but sometimes you doubt them). On top there is a much larger than usual oil "At Sea". The rest are running not a particularly high inventory (but at the same time those numbers are very wild estimates).

Chart 2 is my approximate total marginal production curve, see below sources. It basically says at a given price of oil, how much of world oil production achieves breakeven. It shows a very large supply drop around USD 20, and ramp up above USD 50 (red line is 2014 demand at approximately 92.5 mbpd). Of course this can change temporarily based on producer's reaction. But a physicist would say from the curve itself, that oil is at a stable equilibrium and going nowhere. All trades technical here, nothing macro yet. But build longs below USD 30. The supply drop is too sharp to wait for (or ever reach) USD 20.

Also the there is a fundamental difference between shale production and the low cost OPEC production (apart from the cost of production of course!). In case of shale, the variable cost is relatively much larger. Unlike conventional oil field, the cost of exploration and operation set up is relatively much lower. This makes shale production kind of "on the tap". This, and the fact the production curve looks like the way it is, and the built-up of inventory together make the case for a macro-driven sustainable price rise from here any time soon quite unlikely.

Note the last chart is based on production cost, and excludes building in exploration cost, so probably the range is on the higher side. Balancing this impact on oil price, is the ever-increasing cost effectiveness of alternative energy sources. Now add to this your own opinion about global demand for the medium term, and draw your own equilibrium oil price.

Happy new year.

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Source: see here, here, here and here, for example

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: 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.

Trade Idea: The Short Story of the Long End (USD/GBP/EUR)

Post FOMC minutes, here is a quick look at the current levels of the yield curves across USD, GBP and EUR. Below table gives a snap of how the market currently prices the start of the rate hike cycles (lift-off), the pace of hiking, and the terminal equilibrium policy rates.

As we can see the terminal rate, as well as the pace of hike is highest in case of the US, followed by the UK and the Euro area. This is interesting, esp the change in these since start of 2014. The repricing of lift-off has been large for Euro, by 11 quarters (which is mostly explained by ECB commitment of 2 years worth of QE). For others the lift-off re-pricing has been rather small (almost none for the US and 3 quarters for GBP). What has been remarkably massive is the re-pricing of the terminal rate. Around 190bps for Euro, 145bps for the US and 120bps for the UK. Also note the large re-pricing of the UK pace of hikes, Which is evident in the large push-out of the peak rate timing for (this may be influenced by mismatching supply demand of long end gilts).

I further took these current curves and applied some scenarios on the base case. The scenarios are 1) a 50bps sell-off in terminal rates with faster than expected rate path (the optimistic scenario) 2) a 50bps sell-off in terminal rates with slower pace of hikes (growth with subdued inflation) 3) a 25bps downward revision of terminal rates (a recession scenario) and 4) global convergence - the large global economies converge to a common overall long term rate based on GDP weighted long term nominal trend growth (which turns out to be around 2%).

Overall, the market seems to agree with the secular stagnation theorists more than ever. It also prices in a convergence of global inflation. We indeed have a core inflation convergence (somewhat) for UK and US already. And given UK imports a lot more from Euro area than exports, the case of imported disinflation is strong. The US is more likely to have a higher potential growth than the UK, and is less burdened with Euro area disinflation. Add these up and we may have more that 50bps that is currently priced in, room for long end divergence.

On a relative basis, I think the pricing of terminal rates are okay, except may be a bit too pessimistic. The pace looks balanced too, with an upside risks to faster hike if inflation picks up unexpectedly. Individually, the lift-off for UK is perhaps too early and the pace is too low. I would rather imagine BoE avoiding hiking unless they must. There has been much less talk about bubbles in the UK. And even the London house prices seems to be on course correction. For the US, the lift off seems more or less fine, and the pace possibly as well. But the terminal rates a bit too pessimistic. Given post crisis average nominal GDP in excess of 3.7%, a terminal rates around 2.5% denotes upside around 100bps. On Euro area, well we have QE. It is still not clear the long end has found a support at the current levels. Not to mention Greece and other distraction. And if we have QE extended beyond what is currently promised then everything looks pretty much fair there. Except we have very little downside to go short rates at these levels.

Trade #1: USD 10s30s steepener vs GBP - rationale: see the point on imported disinflation. Also the tight supply and natural long end gilt demand, and a historically tight spread all support this trade. Also historical market rates over the policy rates has been higher for USD than GBP. I prefer 10s30s than other points for this steepener trade. 

Trade #2: Buy USD 1y30y payers vs GBP - rationale: Similar as above, structured through 30y rates, selling the GBP 30y payers. The USD vs. GBP 1y30y vol spread is historically near the tightest levels seen. The election perhaps does not justify all of it.

Trade #3: Long end upside in EUR - rationale: Well we can't go much lower than this and NOT have a prolonged recession. On the brighter side, we can go up quite a bit. The best way to express is outright on the long end. As this has the most asymmetric upside. Can be structured as positive carry trade through bottom right payer spreads. Else through mid-curves at zero cost to carry through 2y in to bottom right forward payer spreads. The vols are relatively cheaper beyond 2y expiries.

Trade #4: Pay UK 2s5s vs US 2s5s - rationale: in case the lift-off date and the pace gets corrected in the UK after the election. And by that time US gets nearer to the lift-off date, leading to relative under-performance of 2y to 5y.

Trade #5: Pay EUR 5s30s vs US - rationale: Euro normalization, vs. downside protection in US for a recession. It is more efficient to express this view via spread options than outright swaps, with chances of large adverse surprise

Finally a brief history of significant sell off in US rates since the 90s. Table below shows change in rates and spreads in bps (Equity is change in S&P in percentage points) over the period of the sell off. The rows highlighted shows cases where long end rates sold off while the policy rate was actually lowered.

All data from Bloomberg.

Macro: Europe Leaking, A Rate Hike to Fight Deflation

Things you must not miss reading this week

1) From the ever-impressive Flow team from JPM (via FTAlphaville) on how Europe is Leaking...
2) A brilliant observation from Michael Pettis on why PBoC should hike rates to fight deflation...

Macro Views Series: A Global Asset Shortage?

Following austerity and fiscal prudence across majority of developed economies, the budget gaps across countries narrowed considerably. This means bonds supply is going to be lower in future. US had the biggest squeeze in deficit, while Germany already runs a balanced budget. To top this, non-sovereign fixed income supply is low as well. Mainly driven by a large fall in mortgage related issuance in the US and Europe, still recovering from the momentary lapse of reasons before the financial crisis

This along with low interest rates, low inflation expectation,  and large central bank balance sheet size, means that not only there is a shortage of safe asset, there can as well be a shortage of assets in general

Most G7 economies offer negative or very low real return – apart from the longer end of European peripheries (based on absolute return (FX Hedged), US and UK the belly of the curves, seem still cheap). In a word, there is little left on the upside for bonds for long term investors. Especially if you are looking for upside and NOT the carry 

Granted equity valuation is anything but cheap on most parameters. But compared to low bond yields, the relative valuation is attractive.  Especially true if inflation picks up from these low levels (Note: the earning yield above is NOT adjusted for leverage).

So if you are not managing grandmas' retirement fund, the equity upside and valuation still remains compelling, compared to other alternatives. Especially from an absolute return point of view.

Of Secular Stagnation and Other Worries

We have seen quite a bull run in the bonds market since the start of the year. Which has caught many people off the guard. The usual suspects are flow chasing yields after equity peaking off the tops, and risk off from Ukraine crisis. But perhaps something more at play here, and we take a look about the secular stagnation and a global japanification that is priced in the rates markets now. After the good rally this week

The peak nominal equilibrium rate priced in is maximum for USD. This is in spite of the recent difference between GBP and USD. This prices in a convergence of UK and US inflation and a higher long term real GDP for US. The recent bullish phase has been less about re-pricing the pace of rate hikes, and more about the terminal rate, i.e. estimate of natural rate of interest. Except in GBP where there is a large re-price of peak rate time (by 3 years!)

This, in my opinion, reflect a much less optimistic re-assessment compared to last year. The terminal rates should be determined by the potential output of the economy, and the pace of hike is an estimate of central bank’s degree of dovishness. This re-pricing of terminal  rate shows a possible shift downward of potential output itself

This brings us back to the pricing of a possible secular stagnation and Japanification. We run a simulation assuming 1) a further 50bps reduction in the maximum future rates (secular stagnation) and 2) as mentioned under 1, but also the maximum rate is attained 8 quarters from the current priced-in pace of hikes. The effect of these on long end rates are obvious, both depress the long end further, and 2) is more severe than 1). 

However, the interesting point to note is how the curve slopes get re-priced. From current level, scenario 1) shows a flattening, while scenario 2) shows a steepening. Indeed the curve slopes in JPY are in general steeper than G3. I think any re-pricing of pace of hike is less likely, especially if inflation has indeed bottomed out (for USD and GBP). We still have a chance for re-pricing of pace of hike for EUR. So as I see it, flattening to continue in USD and GBP, and expect further steepening in EUR.

Oh, and there is this interesting piece from FT Alphaville. Do check the link.