Another year in thrall to the central bankers

December 30, 2012 2:54 pm

by Gavyn Davies

Many year-end reviews of market behaviour in 2012 have rightly argued that the role of the central banks has once again proven critical, trumping all other factors, including the state of the global economic cycle. In fact, two brief statements by ECB President Mario Draghi have been the decisive events in the global financial system this year.

The first, which actually took place in the early hours of a eurozone summit on 9 December 2011, was Mr Draghi’s favourable assessment of the latest political moves towards fiscal union. This unleashed the ECB’s Long Term Refinancing Operations in the first half of the year. The second, on 26 July 2012, came when Mr Draghi said that the ECB would dowhatever it takes” to keep the single currency intact. This led to the launching of the Outright Monetary Transactions programme in September. Although still unused, the mere possibility of unlimited ECB bond buying in Spain and Italy via the OMT was enough to produce a powerful rally in global risk appetite, despite mounting concerns about the US fiscal cliff.

Understanding the developing attitude of the central banks, and the effects of their actions, obviously remains central for investors in all financial assets. The “big picture” for global financial assets, involving very low government bond yields and a gradual shift of risk appetite into credit and equities, is unlikely to change until one of two events takes place.

The first would be a decision by the central bankers themselves that the era of unlimited quantitative easing must end, either because of the risk of inflation and asset price bubbles, or because of concerns about fiscal dominance over the monetary authorities. The second would be a realisation by the markets that further action by the central bankers is irrelevant because they have run out of effective ammunition. Either of these events would probably remove the central prop from the equity bull market which began in March, 2009, but neither seems very likely in 2013.

There is certainly no sign that the central bankers themselves will call a halt to the extension of their balance sheets. The Fed, for example, has just embarked on QE3, an unlimited combination of quantitative and credit easing, despite the fact that Mr Bernanke himself has expressed concerns that the growth of potential GDP might recently have slowed sharply. Instead of concluding that this might lead to inflation risks, implying that monetary policy should be tightened earlier than previously expected, the Fed Chairman seems to have concluded that it is in fact a reason for easing policy even more aggressively.

His reasoning seems to be that the supply potential of the economy is in danger of becoming dependent on, or “endogenous to”, the weakness of domestic demand. This belief in the “endogeneity of supply” (horrible term, I know), under which potential output automatically adjusts upwards and downwards to a level of GDP ultimately constrained by aggregate demand, is something we are likely to hear much more about in 2013. In the US, the main factor leading to the endogeneity of supply is the drop in the labour force participation rate, while in the UK it is the weakness in labour productivity.

Central bankers are inclined to assume that these forces can be reversed if demand grows more rapidly, thus increasing supply potential in line with demand. On balance, they are probably justified in assuming this, but the danger is that inflationary pressures will rise without the central bankers realising it. That is a risk they remain very willing to take.

What about the second risk, that the markets will spontaneously decide that the central banks have run out of effective ammunition? The test case for this hypothesis seems likely to be Japan.

After many years in which the Bank of Japan has increased its balance sheet almost exclusively by purchasing government debt of two or three years’ duration, many investors had concluded that this form of QE was largely irrelevant. This is not surprising, since it involves swapping one very similar asset (short dated JGBs) for another (reserve balances at the BoJ) in bank balance sheets.

It is hard to conceive of a less effective version of QE than that. Nevertheless, Japanese equities and the yen have reacted significantly to the recent arrival of the Abe government, which will force the BoJ to adopt a 2 per cent inflation target in January. Since the mere announcement of a target, without the effective means to enforce it, is unlikely to impress the markets for very long, the key question for 2013 will be whether the BoJ, under its new leadership, is willing to adopt entirely different measures to boost nominal demand.

These measures would presumably have to include purchases of assets other than short dated JGBs to try to boost equities and credit, while reducing the value of the yen. Several different options appear to be under discussion. For example, the Abe government is considering a new fund designed to reduce the value of the yen, under the joint administration of the Ministry of Finance, the BoJ, and the private sector. If this fund leads to a wider diversification of pension fund and insurance company assets into overseas markets, it could have a profound effect on the exchange rate and the future of the economy.

In any event, the markets’ benign response to the arrival of a Japanese government which is pledged to force the BoJ to change its strategy, is very telling. In a different economic environment, this clear demonstration of fiscal dominance over the monetary authorities could easily have resulted in a bond market and currency crisis, but none of this has occurred. Instead, bond yields have moved sideways while equity prices have risen by over 20 per cent. Clearly, the demonstration in Japan that an era of more serious financial repression has arrived has not caused any great alarm in the markets.

One day, the markets may start to react in a much more malevolent way to the prospect of yet more financial repression via endless quantitative easing from the central banks. But that day does not seem to have arrived, and probably will not do so in 2013.

2012 in Review

by Doug Noland

December 28, 2012


“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Mario Draghi, president of the European Central Bank, July 26, 2012

Having singlehandedly altered the course of the European crisis, the Financial Times named Mr. DraghiFT Person of the Year.” Yet “Super Mario” was anything but acting alone. The emboldened Bernanke Fed soon followed Draghi’s bold pronouncement with its own daring commitment to open-ended quantitative easing (in a non-crisis environment!). All throughout 2012, extraordinary monetary easings were announced by central banks around the globe. I will this evening announce the distinguished 2012CBB Thing of the Yearrecipient: congratulations to Endless FreeMoney.”

In my Issues 2012 piece from early-January, I posited that 2012 was a “Bubble year.” The Bubble might burst, with an expanding European crisis as a probable catalyst. But if it persevered, one could expect the potent Bubble to broaden and excesses to intensify. I referred to bipolar outcome possibilitiesso-called left and righttail risks.” In late-July with Spain’s 10-yr yields reaching 7.6% and Italy’s approaching 6.6% - along with the euro sinking to almost 1.20 to the dollar- the European crisis was indeed spiraling out of control. Capital flight within/from Europe and from the emerging markets was becoming a serious issue. A crisis of confidence in the European banking system was in the offing. The world economy was weakening rapidly, and the global financial system was on the brink of a destabilizing bout of de-risking/de-leveraging

As it turned out, those with faith in all-powerful global central bankers end 2012 further emboldened. Ironically, however, 2012 was a year when monetary stimulus actually lost potency. In Europe, the ECB’s $1.3 TN Long-Term Refinancing Operations (LTRO) liquidity facility bought only a few months respite from crisis. 

Despite four years of unprecedented monetary stimulus, the U.S. recovery again disappointed. First quarter GDP was cut in half (from Q4) to 2% annualized, and then dropped by almost half again to only 1.3% in Q2. Ominously, growth faltered in the face of another Trillion plus fiscal deficit and robust corporate Credit growth – and despite the strongest system (non-financial) Credit expansion since 2008 (surpassing 5% in Q2).

Despite ultra-loose monetary policies around the world, global growth slowed meaningfully in 2012. Economies throughout Europe downshifted forcefully.

Importantly, 2012 saw the crisis gravitate from Europe’s periphery to its core. German growth slowed from 2011’s 3.1% to less than 1% (OECD estimates 0.9%). France flat-lined after 2011’s almost 2% expansion. The Italian economy nosedived, from slightly positive growth (0.6%) to a contraction of 2.2% (OECD estimate). Spain also saw positive GDP (0.4%) succumb to recession (negative 1.3%). But it was the worsening of already alarmingly high unemployment that best illustrated Europe’s unfolding recession/depression.

Spain’s unemployment rate jumped to 25% (up from less than 21% in mid-2011). Italian unemployment surpassed 11%, with France following closely behind at 10.3%. The overall eurozone unemployment rate jumped to 11.7% (as of October), from 10.0% in mid-2011. Worse yet, the region’s youth unemployment rate remained shockingly high.

Social unrest became a pressing European issue. Greece’s financial, economic and social collapse gathered momentum. More alarmingly for the continent, tensions erupted in (“core”) Spain. Throughout the region, a backlash against so-calledausterity” took hold. The socialist Hollande was elected President of France, essentially terminating the German/French European policymaking nexus (“Merkozy”). Italy’s Silvio Berlusconi was forced out, replaced by an unelected technocraticgovernment headed by a Caretaker Prime Minister, Professor Mario Monti.

There were instances when European politics made Washington appear highly effective. With seemingly no political solutions to deepening problems in Greece, Spain and Italy, the MIT trained Italian economist, Mario Draghi, took it upon himself to incite dramatic change. His pronouncement of essentially unlimited ECB firepower to backstop troubled European debt markets profoundly altered the near-term risk vs. reward backdrop for periphery debt, the euro, European bank liabilities and global risk markets more generally. When it became clear that the ECB governing council was prepared to disregard the Bundesbank’s strong objections to Draghi’s Outright Monetary Transactions (OMT) plan, the markets believed they finally could enjoy an American-styleBig Bazookaliquidity backstop. The Merkel government backed Draghi, and also made it clear that they saw intolerable risks in a Greece exit (“Grexit”). As they say, “The rest is history.”

With a determined Draghi aligned with the election-minded Merkel government and an unleashed Bernanke Federal Reserve, the market environment was suddenly transformed. Draghi explicitly warned the hedge funds to cover their European short positions – and the speculators quickly appreciated that policymakers were making it advantageous to be positioned leveraged long. 

European debt instruments were transformed from being the global leveraged speculating community’s preferred shorts to their best performing speculative longs. Indeed, with the ECB having negated Europeantail risk,” the prevailing catalyst for global de-risking/de-leveraging had been suppressed. A period of virtual panic buying ensued – in Greek, Spanish, Italian, Portuguese bonds; in the euro; in European equities; in emerging market securities; and in U.S. corporate debt and equities. In short, an historic short squeeze spurred huge rallies throughout global risk markets. Performance-chasing and trend following markets went into overdrive.

Central banks proved, once again, the world’s hero. Heightened fears that global central banks had largely expended their bullets were supplanted with childlike enthusiasm that they essentially retain unlimited ammunition. And with traditional inflationary pressures well contained throughout much of the world, the view held that there was essentially little risk associated with extraordinary monetary stimulus. Whether it was Europe, the U.S. or Japan, the risk vs. reward equation was viewed as strongly supporting aggressive central bank reflationary measures. Along the way, global risk markets decoupled from fundamentals. A critical facet of the “right tailscenario unfolded before our eyes: the historic Bubble strengthened and broadened – global risk market prices inflated and risk premiums deflated - even as the economic backdrop turned increasingly problematic.

The U.S. economy and corporate profits disappointed in 2012, while stock prices posted the strongest gains since the policy-induced rally of 2009. The German economy disappointed, although slightly positive GDP equated with a 29% gain in the DAX equities index. The French economy badly disappointed, so the CAC40 was limited to just a 14.6% advance. The Italian economy faltered, yet stocks were up almost 8%. Spain was a near disaster; stocks fell a mere 5%

The big divergence between fundamentals and stock prices was not limited to the U.S. and Europe. India’s growth slowed sharply, while the Sensex Index gained about 26%. The South Korean economy disappointed, although stocks almost posted double-digit gains. Eastern European economies nearly fell prey to the European crisis, although most equities markets posted big advances for the year. In Latin America, Brazil’s economy slowed markedly, although stocks gained 7%. Argentina became a bigger mess, yet stocks were up 15%. The resilient Mexican economy spurred a 17% advance in the Bolsa Index. 

It is well worth noting the 2012 dynamic where growth slowed in the face of ongoing Credit excesses. In this regard, Brazil and India were notable among major economies demonstrating late-cycle Credit dynamics. In the “old days,” the confluence of rampant Credit expansion and waning economic expansion would have provoked destabilizing capital flight – and a rather abrupt end to booms. But the new world paradigm is one of unlimitedquantitative easing” and currency devaluation from the world’s major economies. This global Bubble Dynamic sees unleashed central banks promoting unleasheddeveloping worldCredit systems

As an analyst and student of Credit, I remain in awe of Credit happenings in China. First of all, Chinese economic growth also slowed meaningfully in the face of ongoing historic Credit expansion.

According to Reuters, total bank lending has been on course to approach $1.4 TN, an increase of almost 14% from booming 2011. Even more amazing is the growth of non-bank Credit. According to Bloomberg, Chinese corporate debt issuance surged 54% in 2012 to $657bn. Moreover, some analysts have estimated annual growth as high as 50% for lending outside of China's normal banking channels. 

According to Barclay’s, the Chinese “‘shadow bankingindustry has nearly doubled in the past two years to $4.11 trillion, or more than a third of total lending.” While a complete and accurate accounting of Chinese Credit is not available, it is possible that total 2012 Chinese Credit growth approached the U.S. record of $2.5 TN posted in 2007. I have posited that Chinese authorities lost control of their Credit boom back during the aggressive 2009 stimulus period. I have similarly suggested that China is trapped in a late-cycleterminal phase of Credit excess.” I saw only support for this thesis in 2012

That historic Chinese Credit growth actually accelerated from 2011 levels – and that minimally regulated, high-risk and opaqueshadow bankingCredit exploded – is an important aspect of my “right tail” (Bubble grows much more precarious) year-in-review 2012 analysis. And in what I would contend is a virtual global phenomenon, Credit was expanded in larger quantities, with a riskier profile and with record high market prices. Or stated somewhat differently, global Credit became meaningfully riskier although that did not stop much of it from being re-priced at even more inflated levels

Various recent headlines support my “right tailanalysis: “Record-setting Year for Corporate Debt;” “Record Year for Junk Bonds;” “Mortgage Bonds Soar on Fed’s Refinance Push;” “[Corporate] Sales Approaching $4 Trillion in Stimulus Repast; “A Banner Year For Riskiest Debt;” “Forth-Quarter M&A Surge Spurs Optimism..;” “Leveraged Loan Volume: $456bn in 2012, Thanks to Torrid Fourth-Quarter Market.”

According to Bloomberg (Sarika Gangar), global corporate bond sales this year just surpassed 2009’s record $3.89 TN. Companies from the neediest to the most creditworthy took advantage of borrowing costs that fell to a record-low 3.27% this week as central banks held down interest rates to prop up the economy.

Investors also funneled $475.3 billion into bond funds as global growth, which slowed to an estimated 2.2% this year from 2.91% in 2011, prompted them to seek alternatives to equities.” The first, third and fourth quarters all posted record issuance for their respective periods.

“The yield on bonds worldwide fell 1.56 percentage points this year. Borrowing costs have tumbled from an all-time high of 9.05% in October 2008. Issuance in the U.S. reached a record, climbing 31% to $1.47 trillion, exceeding the previous all-time high of $1.24 trillion in 2009. Sales of high-yield bonds reached $354 billion. That’s 23% above the previous record of $288 billion set in 2010.” According to Forbes’ Steve Miller, U.S. leveraged loans jumped 24% from 2011 to $465bn, with lending volumes below only 2006 and 2007 levels.

Instead of the forces of de-risking/de-leveraging, Credit instruments enjoyed manic demand. It is worth noting that 2012’s record $475bn bond inflows compares to 2011’s $99bn. A virtual buyers’ panic ensured double-digit returns for corporate debt investors. And the riskier the paper, the higher the 2012 return

When Total U.S. Mortgage Credit expanded $1.4 TN in 2005, there was no doubt that the Mortgage Finance Bubble had inflated to dangerous extremes. That did not, however, stop a fateful $1.0 TN of subprime mortgage CDO (collateralized Debt Obligations) issuance in 2006. In 2012, global central banks and governments gave the great global Credit Bubble an additional lease on life. Markets responded, not uncharacteristically, with only greater speculative excess. Speculative markets responded by only diverging further from fragile fundamentals

Those market operators most adept at betting on policymaking enjoyed yet another year of stellar returns – along with more incredible growth in AUM (assets under management). The cautious fell only further (and further) behind. The hedge fund community lived to play another day, although with each passing year it seems to become more a story of the giants growing more gigantic. 

There were notable prosecutions of insider trading, yet never in history has inside knowledge of policymaker intentions provided such incredible opportunities for riches. At the Federal Reserve, policies accomplished the objective of spurring the lowly saver further into risky securities. Overall, central banks succeeded in bolstering vulnerable global securities markets. Meanwhile, it became increasingly clear throughout 2012 that years of easy money, myriad (ongoing) policy mistakes and attendant misdirected resources have taken quite a toll on the underlying structures of economies throughout Europe, the U.S., Japan, China and around the globe. 

In response to deepening structural issues and in the face of ongoing global imbalances, central bankers further ratcheted up their runaway monetary experiment. Seemingly putting an exclamation point on an extraordinary year, December saw the Fed announce $85bn of monthly quantitative easing. Numbed by such incredible monetary largesse, the marketplace can be forgiven for downplaying U.S. fiscal cliffissues and economic vulnerabilities. In Japan, a new government was elected with a mandate to essentially do whatever it takes” with fiscal and monetary policies to spur growth and inflation. With over two decades having passed since the bursting of their Bubble, Japan’s search for solutions has turned desperate. Globally, increasingly desperate politicians and extraordinarily accommodative central bankers make a most perilous combination

The years pass by quickly. It remains a privilege to chronicle history’s greatest Credit Bubble on a weekly basis. I have a rather demandingday job,” but I’ll continue to do my best to put together my weekly Bulletins. I only write on Fridays, and I never really know how much time I’ll have available. The quality will vary, and there will continue to be those tired and grumpy Fridays to contend with. But I love the analysis and I’m honored that you would take the time to read my workwarts and all. Thank you.

A Second Chance for European Reform

Hans-Werner Sinn

27 December 2012

MUNICH – The European Central Bank has managed to calm the markets with its promise of unlimited purchases of eurozone government bonds, because it effectively assured bondholders that the taxpayers and pensioners of the eurozone’s still-sound economies would, if necessary, shoulder the repayment burden. Although the ECB left open how this would be carried out, its commitment whetted investors’ appetite, reduced interest-rate spreads in the eurozone, and made it possible to reduce the funding of crisis-stricken economies through the printing press (Target credit).
This respite offers an ideal opportunity to push forward with reforms. Greek Prime Minister Antonis Samaras must convince his countrymen that he is serious about implementing them. Spanish Prime Minister Mariano Rajoy and Portuguese Finance Minister Vitor Gaspar deserve more support for their plans. And one can only hope that Italy’s caretaker prime minister, Mario Monti, contests the next general election. All of these leaders understand what must be done.
France, by contrast, does not appear to have noticed the writing on the wall. President François Hollande wants to solve his country’s problems with growth programs. But when politicians say “growth,” they meanborrowing.” That is the last thing that France needs.
France’s debt/GDP ratio is already around 90%; even if its 2013 budget deficit does not exceed 3.5% of GDP, its debt/GDP ratio will have climbed to 93% by the end of the year. The government’s GDP share, at 56%, is the highest in the eurozone and second highest among all developed countries.

It is not only film actors like Gérard Depardieu who are leaving the country to escape its high taxes; industry is fleeing as well. France’s once-proud carmakers are fighting for survival.
Indeed, France’s manufacturing industry has shrunk to barely 9% of GDP, less than Britain’s manufacturing share (10%) and less than half of Germany’s (20%). Its current account is sliding into an ever-deeper deficit hole. Unemployment is rising to record levels.
France’s basic problem, like that of the countries most affected by the crisis, is that the wave of cheap credit that the euro’s introduction made possible fueled an inflationary bubble that robbed it of its competitiveness. Goldman Sachs has calculated that France must become 20% cheaper to service its debt on a sustainable basis.
The same is true of Spain, while Italy would have to become 10-15% cheaper and Greece and Portugal would need domestic prices to fall 30% and 35%, respectively. The OECD purchasing-power statistics paint a similar picture, with Greece needing to depreciate by 39% and Portugal by 32% just to reach the price level prevailing in Turkey. But, so far, virtually nothing has been done in this respect. Worse, some of the troubled countries’ inflation rates are still running higher than those of their trading partners.
Eurozone politicians tend to believe that it is possible to regain competitiveness by carrying out reforms, undertaking infrastructure projects, and improving productivity, but without reducing domestic prices. That is a fallacy, because such steps improve competitiveness only in the same measure as they reduce domestic prices vis-à-vis eurozone competitors. There is no way around a reduction in relative domestic prices as long as these countries remain in the currency union: either they deflate, or their trading partners inflate faster.
There is no easy or socially comfortable way to accomplish this. In some cases, such a course can be so perilous that it should not be wished upon any society. The gap is simply too large between what is needed to restore competitiveness and what citizens can stomach if they remain part of the monetary union.
In order to become cheaper, a country’s inflation rate must stay below that of its competitors, but that can be accomplished only through an economic slump. The more trade unions defend existing wage structures, and the lower productivity growth is, the longer the slump will be. Spain and France would need a ten-year slump, with annual inflation 2% lower than that of their competitors, to regain their competitiveness. For Italy, the path toward competitiveness is shorter, but for Portugal and Greece it is substantially longer – perhaps too long.
Italy, France, and Spain should be able to regain competitiveness in the eurozone within a foreseeable period of time. After all, Germany cut its prices relative to its eurozone trading partners by 22% from 1995, when the euro was definitively announced, to 2008, when the global financial crisis erupted.
Ten years ago, Germany was like France is today – the sick man of Europe. It suffered from increasing unemployment and a lack of investment. Most of its savings were being invested abroad, and its domestic net investment share was among the lowest of all OECD countries. Under growing pressure to act, Gerhard Schröder’s Social Democratic government decided in 2003 to deprive millions of Germans of their second-tier unemployment insurance, thus paving the way for the creation of a low-wage sector, in turn reducing the rate of inflation.
Unfortunately, thus far, there is no sign that the crisis countries, above all France, are ready to bite the bullet. The longer they cling to a belief in magic formulas, the longer the euro crisis will be with us.

Hans-Werner Sinn, Professor of Economics at the University of Munich, is President of the Ifo Institute for Economic Research and serves on the German economy ministry’s Advisory Council. He is the author of Can Germany be Saved?