Two ironies and the markets' impromptu

We are indeed living in interesting times, not least regarding the way policy responses have evolved in recent years.  

This is especially true for monetary policy in the developed world.

Policy design has come a long way since the seventies and the associated big lessons for central bankers.  We have experienced ‘goldilocks’, the ‘taming of inflation’ and the ‘Great Moderation’, until the credit crisis hit in 2008 and everything went into ‘emergency mode’.

Then the provision of financial heroine by central banks was ‘legalized’ by governments. That was justifiable at the moment, as is the use of heroine on warzone victims for medical purposes.

However, concern about the effects of subsequent addiction was ‘postponed’ for later—much like the ‘fiscal cliff’-related measures have been ‘kicked down’ to be dealt with in 2013, in line with standard political practice these days.

The recent era of ‘low and stable’ inflation in the developed world has been credited with providing the backdrop for healthy economic growth. 

This was largely achieved through a policy approach of 'inflation targeting' (explicit or implicit). 

However, we are now witnessing a gradual departure from this framework on the part of central bankers towards ‘doing whatever it takes’—even substituting for the lack of proper fiscal policy initiatives.

In this context, the amount of money printing that has taken place (and will likely continue to take place—see, for example, the FOMC’s latest policy statement) is unprecedented.

The route taken by ‘Helicopter Ben’ and ‘Super Mario’ is almost guaranteed to lead to severe inflationary pressure buildup—not necessarily ‘hyper-inflationary’ like doomsayers preach—going forward. It is likely a matter of when, not if.  Talk of the ability/tools to ‘mop up’ the excess liquidity at the right time, smoothly, etc. is just unrealistic.

There is a growing (largely implicit, for now) willingness by central bankers to subordinate inflation as a policy concern in the name of boosting employment and growth.

See, for example, this article in the Financial Times (“King signals inflation not primary focus"):

Sir Mervyn King has given his clearest admission yet that he no longer believes price stability should be the Bank of England’s sole objective, arguing that central bankers should be flexible with inflation targets to head off future financial crises”...

…Sir Mervyn said it would be sensible to recognise that sometimes it was right to “aim off the inflation target for a while” to moderate the risk of crises.

“Monetary policy cannot just ‘mop up’ after a crisis,” he said, adding that the intellectual framework underpinning monetary policy needed to be reassessed.

The first irony is this. The once overarching goal of price stability, which made (a sense of) prosperity possible, is now gradually becoming subordinated to what could be summed up as ‘the incapacity of governments to get their act together and conduct proper fiscal policy’.

What is often not being stressed, however, is that this environment of price stability made fiscal irresponsibility possible in the first place. A higher-inflation era is shaping up to be the price paid for this behavior.

The second irony relates to a contrast between developed and emerging/developing economies—China in particular. 

As Jonathan Ruffer correctly points out in his latest commentary:

“The point of inflation coupled with interest rates below that rate of inflation is to transfer wealth quickly and effectively from the saver to the battleground of the borrower”.

Indeed, negative real interest rates act to subsidize the borrower at the expense of the saver. Is this not what has been going on for a long while in China…which is now attempting to ‘rebalance’? Has this change not been encouraged by Western governments for years?

However, it seems that the tables may be turning: at the same time that China has vowed to rebalance its economy away from this distortion, the western world could be looking into an era of financial repression and runaway inflation.

For now, markets have been in ‘impromptu mode’, adopting a stance of appearing ‘politely thankful’ for the promise of enormous liquidity-pumping. But are they really? Should they be? Or is this just a moment of inertia?

Markets will certainly have to do a lot more improvising down the road, in what is a very fine balance of risks that will become clearer when the longer-term consequences of this policy ‘path’ eventually start receiving more focus (especially after the US election).

Although these may still be early days, the higher price of gold and recent outperformance of gold mining stocks vs. the broad market may be sniffing investor concerns.

As Ruffer puts it: “The markets, the inflation rate, the experts and the populace remain quiescent – but sooner or later that will change – and suddenly.”

Is Buying Time the New Steady State?

Could the concept of “buying time until a solution is generated” have come to be regarded as the “solution” itself, given the nature of the political backdrop in Europe, as well as in the US?

The approach of “buying of time” implicit in recent ECB and Fed action/rhetoric exemplifies the constraints imposed by political inertia in the design of economic policy.

Political leaders have largely been reactive/behind the curve, adopting a largely short-termist perspective.

The procrastination of Eurozone leaders has cost a lot of pain and time in attempting to contain the crisis.

Likewise, failure to effectively address the ‘fiscal cliff’ has led to a protracted period of weak business sentiment in the US, weighing substantially on the prospects of economic growth. 

The so-called ‘political cost’ is simply too large to ignore.

In a sense, the contribution of central banks has become the ‘only game in town’, in stark opposition to slow, often deficient decision-making processes and lack of wholehearted initiative on the part of governments; esp. in the Eurozone.

To put it differently, necessity (central bank contribution via monetary policy measures) has come to be seen as ‘quasi-sufficiency’ in a world of subpar political leadership.

This is potentially very dangerous, both from the monetary and fiscal policy angles.

The farther into uncharted territory central banks go, the greater the risk; markets become ‘addicted’ to central bank action, the associated measures’ effectiveness is arguably diminishing in strength with time and the eventually inevitable ‘exit strategy’ situation becomes more unpredictable.

Likewise, the longer governments keep choosing to avoid confronting reality head on, the harsher the consequences down the line are likely to be.

It is interesting that expiry of the fiscal cliff-related measures is automatic; politicians had simply agreed to postpone having to think about key issues until a later date..

The ‘reality’ is two-fold: fiscal policy should work with, and not rely on, central bank initiatives; AND

the appropriate planning-horizon now, more than ever, has to transcend political ‘cycles’ such as a presidential term.

Yes, both Europe and the US need to reduce their debt levels (and debt/gdp ratios), but a gradual phasing-in of the necessary debt-curbing measures is of utmost importance.

It is in the nature of ‘balance sheet’ recessions to require a longer timeframe when it comes to economic policy design.

Policy uncertainty can never be conducive to boosting ‘animal spirits’, an essential element for any recovery.

Coming to accept that high doses of policy uncertainty have become a part of the ‘steady state’ would be detrimental to the global economy.

‘Economic’ is meant to encompass ‘monetary’ and ‘fiscal'. 
It is in this combination where any type of 'solution' has to be founded. And a pragmatist would certainly argue that this solution will not come in the form of a one-off, 'bazooka' kind of response, but a long-term framework plan that goes beyond political self-interest (hence can be gradually and credibly enforced).

This is no time for complacency. Let’s hope that “buying time” as the bridge to a “solution” does not come to be perceived as the solution itself.  Because it cannot be.


Below, an interesting interview of Marc Faber on Bloomberg earlier this week.

Waiting for next week's signs

Equity markets are consolidating. Both the SPX and DAX are sitting close to their 200-day MAs, awaiting direction from the Greek vote, European reaction and Fed meeting next week.

Meanwhile, the VIX is also close to its 200-day MA, also suggesting a 'finger on the button' kind of mode.

The Gold/Silver ratio is also at a key level.  This ratio appears to be more relevant/useful as a reflection of sentiment with regards to the market's perception of (expected) liquidity conditions at times of stress.

Definitely one to watch next week.

In the same vein, the Gold/WTI crude oil ratio, on the rise since the middle of March, has signaled a 'peaking' SPX. Will Gold/WTI move towards the levels seen in early October 2011, when risk sentiment bottomed out following a wild summer selloff? 

Market indicators seem to confirm a sense of heightened tension and anticipation at the moment. Let us see what next week brings.

Carrot and stick

When it comes to the process of European integration, one cannot help but note a 'carrot-and-stick' approach on the part of Germany. The carrot is a 'banking union', with elements like euro-wide deposit insurance, direct bank recapitalization, etc. The stick is a more comprehensive 'fiscal compact', with enhanced discipline and a reduction in national sovereignty by 'stealth'.

It is true that some degree of euro-wide 'order' on the fiscal front is necessary in order to address the moral hazard issues associated with greater European integration. And Germany is right to stress that fiscal/political union is a prerequisite for establishing a (more 'technical' in nature) banking union.

The key here is to focus on the dimension of time. Markets and market observers always urge for direct action, steps to be taken towards rectifying imbalances fast. They can afford to adopt a 'means to an end' approach, with demands for immediate implementation.

However, profound reforms such as the ones called for in Europe cannot be properly achieved in a matter of weeks or months. And when governments try to 'play with the market' and go for immediacy, the results leave a lot to be desired. A prime example of this is the insistence for harsh 'internal' devaluation in the 'bailed-out' countries as a means to regaining competitiveness; the more optimal/sustainable/growth-enhancing route of structural reforms simply takes 'too long' in political terms.

What is at stake involves the broader political issue of 'deciding to live together'; formation of a political union is the absolutely necessary bedrock of sustainable, genuine and enforceable economic/banking solutions.

Where the key lies here is twofold:
1) constructing a roadmap that is gradual (by necessity), credible (openly endorsed by political leaders without qualifications) and realistic (allowing for some degree of slippage along the way).
2) avoiding the existing approach of, just-in-time 'solutions', 'can-kicking' and persistent lack of 'one voice' (e.g. EU Commission vs. German officials) that has resulted in a series of 'half measures' so far. The most recent straw on the pile of half measures formed during the last two and a half years is the Spanish banking bailout. Its 'half' character is evident in the speed with which initial enthusiasm (merely short covering?) in financial markets fizzled.

Spanish 10yr sovereign bond yield

The second point is equally important with the first. In fact, it is even more important in the short term, in order to start gaining credibility with the markets.

The longer half measures remain the main ingredient of policy response in Europe (notwithstanding voices in the background calling for a braver and faster-moving agenda on the fiscal front), the more will the crisis continue moving along (Greece, Spain, Italy next?). And the more the crisis continues moving along, the greater the consequences when the breaking point arrives.
Procrastination is not only a prelude to economic stagnation (or stagflation down the road, esp. if and when the ECB feels the time is ripe for it to 'blink'), but also the catalyst for 'predictable escalation' of contagion in Europe.

Interestingly, this has particular implications for Greece. Heroic approaches driven by narrow-minded political aspirations are always a dangerous path to follow. This is even more important now, as Greece is in the delicate (largely self-inflicted) position of potentially becoming the catalyst for a sea change in European politics. A Greek government that refuses to be pragmatic and/or cooperative runs the real risk of 'exclusion' from the 'next day' of Europe's modus operandi.

Things usually get going when a visible example of the alternative becomes a real picture. A non-compliant Greece could easily play that role. It would be the hard way for everyone, but especially for the Greek people.

Michael Tory writes in the FT:
"The answer to the question of where to draw the line between worthy and unworthy countries is simple: eurozone institutions will help those countries that first help themselves. So we should not continue this never-ending, confidence-sapping series of half-measures to buy yet more time: at best they will postpone defeat while magnifying its eventual effects. It is now time to let Greece go in order to catalyse and legitimise the measures needed to save the rest."

This line of argument has been gaining strength recently, but Greek leaders keep offering plenty of ammunition to proponents of the 'Grexit' view.  Greek politicians should stop throwing extra straws on the back of a camel that is already near its breaking point. Because when it breaks, there is no turning back.

It would be fair to describe the Euro project as founded on Treaties of 'mutual distrust', not agreements aiming to bolster an existing trend that favours a voluntary (not PSI-style, of course..) arrangement to 'live together' (as opposed to being forced to live together). There is a real danger that the fiscal compact turns out to be just another of those Treaties, if the political capital behind it remains half-hearted. And the scale of the project, as well as its philosophy, do not leave much room for reluctance/wishful thinking.

Let us hope that a 'Greek accident' (á la Lehman) does not provide the kind of fear that can nurture compliance, discipline and feet-dragging to a new set of rules, as this would only act to magnify inherent 'imbalances' in the system. Because the real tragedy could then come from extreme/nationalistic politics taking centre stage in Europe, with unforeseeable implications for everyone.

Immediate checkpoints that will drive markets in the short term are the Greek election (17/6) and the Fed meeting (20/6).
The Fed seems to stand increasingly ready to act, but (as does the ECB) would like to see what comes out of Greece first.
Below, an interesting interview of Jim Bianco (Bianco Research), who argues that Fed accomodation is actually holding the US economy back.

Current thoughts

We seem to be getting nearer to an inflection point in financial markets.

This suggests expectations of a policy response are becoming increasingly relevant.  In fact, we already have a first concrete sign, with the People’s Bank of China (PBOC) cutting its benchmark rate for the first time since 2008.

Europe, US, China

Let us take what I call the three ‘pillars’ of the global economy, in turn.

1. Europe: concern remains elevated, both on ‘governance’ issues (Greece, Spain, euro breakup talk) as well as the economic growth front, with economic data implying stagnation, at best, with the exception of Germany (but for how much longer..?)

2. US: macro data has come out on the softer side recently, signaling that recovery may be losing momentum. The employment numbers, to which the Fed is particularly sensitive, appear to be on a deteriorating trend, missing expectations by a wide margin for May.

3. The Chinese economy has been exhibiting signs of persistent weakness. Soft data, such as the manufacturing PMI are indicating growth problems, also evident in ‘harder’ data such as industrial production growth. Further, indicators like electricity production and iron ore demand have not been encouraging.

The Chinese authorities’ concern about rising inflation has led to an aggressive clampdown on the property market with some success, as inflation has stabilized/turned lower. However, the Chinese economic growth model remains substantially dependent on investment/real estate development, and this cannot change overnight.

Today’s rate cut by the PBOC suggests the government’s line in the sand has been crossed.

Unlike previous occasions, when the PBOC started easing policy first through  a series of reserve requirement ratio reductions, this time a rate cut arrived ‘too fast’, potentially illustrating a sense of urgency.

The rate decision came before a raft of data to be announced this coming weekend, including industrial production and retail sales, suggesting numbers may be on the soft side. Furthermore, the Chinese may be getting increasingly pessimistic about the future course of the Eurozone.

The question here is whether to welcome this move at face value, OR see it as confirmation that ‘something is really not going well’ in China. Commodity price behaviour certainly seems to be suggesting the latter for a while now.

4.Other monetary authorities around the world have recently been ‘erring on the side of caution’ by opting to be more accommodative than otherwise, as a result of concern that another ‘Lehman’ event springs from the Eurozone.  For example, the Reserve Bank of Australia, the Banco Central do Brazil and the Reserve Bank of India have all reduced rates in recent weeks, explicitly citing the external uncertainty in their rationales.

Market stress and the coming response

Risk sentiment has been seriously hurt in the last month or so.

Equities have shed most of their year-to-date gains and 'safe haven' sovereign bond yields have reached extremely low levels.

Elements of a policy response are starting to fall into place.

The ECB stands ready to act, as president Draghi mentioned yesterday. Europeans usually take a bit longer before launching ‘solutions’, but a customized package for Spain and its banks appears to be on the cards.

Chairman Bernanke has also mentioned the Fed is ready to act if the US economy becomes ‘threatened’ by Europe. Rhetoric from other Fed officials has also in recent days highlighted alertness and left the door open for further stimulus, should the economic recovery show signs of exhaustion. Importantly, declining energy prices are giving more ‘room’ to the Fed, should it decide on acting.

Nevertheless, the ‘QE glass’ may still be half- empty and the Fed probably needs to see more before acting.

Such ‘readiness’ by monetary authorities may constitute a necessary, but cannot be a sufficient condition for addressing structural issues that require political will.

Three points worth making here:

First, it is once again to central banks that everyone looks to for ‘support’. The vacuum of fiscal presence is remarkable.

What is more, I am worried about China’swillingness or ability to deliver another ‘2008’. While China’s debt situation is probably much better than in most of the developed world, it is not exactly ‘healthy’, which makes it unlikely that the authorities have the appetite for another huge fiscal stimulus package. Furthermore, even if they did, it would in all probability act towards ‘undoing’ most of the progress made in tackling inflationary pressures (and expectations thereof). In addition, a fiscal package, almost certainly geared toward infrastructure investment, would not be entirely consistent with rebalancing towards a more sustainable, consumption-driven economic model. And let us not forget that there is a Party leader handover next year, hence one would expect the current authorities to not aim at major new policy initiatives in the meantime.

Second, notwithstanding the monetary authorities’ readiness to act, one should remember that such interventions merely ‘buy time’. 
More importantly, key developments/sources of uncertainty are still ahead of us.

In the case of Europe, there is ‘can-kicking’ until politicians get their act together. Chancellor Merkel is now talking about a ‘two-speed’ Europe…this can only add to market nervousness if not clarified / backed up by concrete proposals. Also, the Greek election is only ten days away.

In the case of the US, the ‘fiscal cliff’ approaching towards year end, the debt ceiling is bound to be reached again and there is an election coming, with all the associated uncertainty/political gridlock this could bring.

Third, central bankers may be standing ready, but not in an unqualified sense. Inflation remains a key concern and, as illustrated by the Bank of England’s decision today, monetary authorities still aim to keep a delicate balance.

The market has been ‘sniffing’ the policy response. Equities have bounced back from oversold levels, 'safe' sovereign bond yields have edged up a bit, gold and silver have moved higher since the US non-farm payrolls number, while the USD has shed some ground.

However, the rally that followed China’s rate cut did not last, or was not as strong as one would expect. Lack of hints for imminent QE from Bernanke today may have also dented the initial enthusiasm, something evident in gold's move lower.

Unless Europe miraculously and decisively resolves its issues in the next few weeks, the policy response will get more and more necessary and will likely not be denied by the monetary authorities. 
This is a sentiment/event-driven market, so reasonable valuations (esp. Europe) are getting trumped by the macro. We are likely heading to a very interesting summer for financial markets. 
Let us hope that uncertainty does not give rise to a 'Lehman' scenario materializing, as even central bank response has its limits.

European procrastination a prelude to global stagflation?

Procrastination
Once again the theme of procrastination has emerged in the Eurozone crisis. This time it revolves around Spain and the tip of the iceberg is the rescue of ailing Bankia (= sum of the cajas).

Two long-standing pressure points stand out, that have consistently characterized Europe since the Greek crisis erupted.

First, lack of the proper institutional framework for dealing with crises is leading to lots of 'wasted time' and the associated escalation in uncertainty. These, in turn, have an impact on financial markets as well as the general health of economic activity.
There are calls for empowering the ESM to make direct recapitalizations and sever the existing link between banks and sovereigns to be when it comes to aid for banks in trouble.

It is worth pointing out that the ESM was conceived at the time as part of the 'solution' for tackling future crises.
Well, here we are...the future is now and now is the future, as the Greek crisis is very much alive and we are moving slowly (?) but surely to simply add more 'episodes' (e.g. Spain currently) along the way.

It is like throwing water on fire, when there is a variety of fire-fighting chemicals out there...But of course they have to be paid for. We are getting to the point when the fire is close to getting out of control and everybody is hoping that it is going to rain. The Europeans are dragging their feet once again.

Second, we continue to witness the ongoing 'clash' between different institutional sources of authority; usually it is the EU Commission vs. Germany, with the ECB standing in the middle...like an adult between two children fighting. No progress here either.

Indicative is the situation experienced around this time last year (May 2011), when Europeans were starting to warm up to the idea of a 'voluntary' agreement of Greece's private creditors on a 'haircut'. Chancellor Merkel started talking publicly about it, while France's stance was to categorically oppose the scenario of restructuring and the EU Commission half-heartedly suggested 'reprofiling' (i.e. just playing with words that essentially mean the same things) as a possibility..


Stagflation
Now, procrastination and indecision by the Europeans have been key factors depressing economic activity worldwide. Uncertainty freezes business decision-making, funding for SMEs remains scarce/unavailable, etc.

One can spot signals which suggest that the world economy may be entering a stage increasingly characterised by stagflation.

Extremely loose monetary policy in the developed world is set to persist/strengthen in the near/medium term. While not immediately translating to inflationary pressures, it is a very open question even to central bankers how there will be a successful 'mopping up' of all this liquidity without damaging growth prospects when the time comes. Authorities' profile of incentives on liquidity provision remains skewed/asymmetric, not least in order to avoid a debt-deflation spiral.

In the developing world, seeds of stagflation are becoming more evident.
India's GDP growth in Q1 2012 came in at an annualized 5.3%yoy (versus 9.2% in 2011), an eight-year low, with sharp declines in industrial production and exports being the norm recently.
Meanwhile, inflation remains elevated at 7.3%yoy despite a series of aggressive interest rate hikes by the RBI throughout 2011. The RBI has recently reversed course in order to stem the growth slowdown as the government tries to rein in its budget deficits. Foreign capital flows have all but dried out, the trade deficit has widened to a record, and the Indian Rupee has reached all-time lows versus the USD (a further fuel to inflationary pressures and expectations thereof). The RBI has tried to intervene in order to send a message to financial markets and stem the currency decline.



In fact, this is becoming a more general feature in the developing world recently, further evidence of stress in financial markets.

As Bloomberg reports:  
Just three months ago, emerging nations from the Philippines to Brazil were intervening in foreign exchange markets to make exports more competitive. Now they are selling dollars to stem currency declines and quell inflation. 

“Inflation is still an issue for a number of emerging- market countries,” said Callum Henderson, global head of currency research at Standard Chartered Plc in Singapore. “At the same time, growth is an increasing concern for those countries vulnerable to the European debt crisis. Policy makers have to try and strike a very careful balance.”

In Brazil, Banco Central do Brazil, with the government's 'blessings', has been slashing rates since mid 2011 in effort to boost growth (down to 2.7% in 2011 from 7.5% in 2010) and arrest the Real's strength (Brazil was among the small number of countries with positive real interest rates). Inflation is still high, but has been coming down recently.
Expectations out of Brazil are gradually converging with the reality of 'trouble' in the world, with the Bovespa index clearly reflecting this trend.

However, the stakes are getting higher, and the associated fragility harder to handle the longer such an approach remains in place.
As Beyondbrics reports: 
Moody’s Latin America director Alfredo Coutiño, had this to say:

After today’s decision, monetary conditions have fallen below neutrality, since the nominal policy rate is lower than the neutral 9 per cent. If economic activity remains weak and advances slowly, monetary conditions will need to be pushed further into expansionary territory in coming months. Lower interest rates will restore the currency competitiveness and will help the national industry to quit recession.

The danger lies with potential un-anchoring of inflation expectations as the economy appears to respond to stimulus. Furthermore, political 'suasion' on the central bank has been steadily rising in Brazil and could have an impact of foreign investors' confidence.

China has so far managed to contain inflation through drastic intervention in the property market. Growth has been slowing, so the tipping point for a shift in the authorities' stance may be getting closer. Also, it is interesting to think about what the effect of 'rebalancing' (towards more domestic consumption, less investment, less reliance on exports for growth and some financial system liberalization) will be on the growth/inflation mix going forward.

Anthony Boeckh puts it well in a recent note (3/5/2012):

"Price inflation has softened recently in a number of countries.  Headline price inflation in the U.S. has slipped from 4% p.a. to a little under 3%, in the eurozone from 3% to 2.7% and in the UK from over 5% to 3.4%.  China’s non-food and producer price changes have actually moved into negative territory.  India and Russian inflation numbers show a decline from recent peaks of around 15% to the 6%-8% range.  Agricultural and industrial metal prices have dropped about 20% from the peaks of a year or so ago.  So, from a close up snapshot, one could ask, “Where is the inflation problem?”  However, that misses the point.  Price inflation is all about excessive money, credit and fiscal deficits.  When they work their way through the system, prices go up.  The key variable is the time lag."

I am not claiming that stagflation on a global scale is imminent. However, it is important to keep track of what is going on below the radar at a time that everybody is thinking about Greece, Spain, banking unions, etc. Not least because developments in Europe have been and will continue to be a key input of authorities' reaction functions in the rest of the world.