Markets Insight

September 3, 2012 4:19 pm
 
Fed ready for further experimental easing
 

How should investors react to Ben Bernanke’s much-anticipated speech last Friday at the annual Jackson Hole Symposium of central bankers?



Here are key takeaways and, more importantly, what the remarks by the Federal Reserve’s chairman imply for markets going forward.



Perhaps with an eye on protecting his legacy (and responding to political attacks), Mr Bernanke went out of his way to provide a robust defence of the Fed’s unconventional monetary policy.



He did so using historical analyses, some preliminary model results and whatever academic work he could find for what is still unfamiliar territory”.



Mr Bernanke left no doubt that he is willing to continue to press the policy envelope further out – even while acknowledging that both the benefits and costs of non-traditional monetary policy are uncertain.



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His willingness to use imperfect tools to pursue what have been largely elusive macroeconomic objectives is more than just a function of the “daunting economic challengesfacing the US.




He believes that the domestic headwinds reflect more cyclical structural factors. He rightly worries that the longer they persist, the greater the threat that cyclical problems could become structural in nature.


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Echoing the minutes of the last Federal Open Market Committee meeting, Mr Bernanke stressed that he is not looking for just any pick-up in jobs. He is correctly targeting a “sustained improvement in labour conditions”. This suggests that he would keep his foot on the policy accelerator even if employment indicators start to ameliorate.



Mr Bernanke also sees a need to “take out insurance against the realisation of downside risks”. I suspect that this reflects concerns about the US fiscal cliff, Europe’s debt crisis and geopolitical instability in the Middle East.



While signalling that both baseline analysis and risk scenarios justify greater policy activism, he stopped short of providing details on the individual measures he favours. Instead, he retained optionality on an open-ended list, also managing to frighten short-sellers who doubt his ability to deliver.



Investors with long market positions cheered the speech. Indeed, every major market segment traded higher in price – from equities to government bonds and from corporate credit to commodities.




It is tempting to attribute this broad price rally to the belief that all financial assets will benefit uniformly from repeated injections of Fed liquidity. But this is where investors should be more nuanced.



Depending on the market segment, there can be significant and variable gaps between what Mr Bernanke is willing to do (a lot, and bolstered by the fact that the Fed is undershooting both components of its dual mandate); what he is able to do (more limited since he is forced to resort to imperfect tools and without the support of other policy making entities); and ultimate effectiveness (even more limited given sluggish policy transmission mechanisms and insufficient global policy co-ordination).



Investors should not fight the Fed when it comes to what this institution, with its printing press, can deliver with a high degree of confidence – namely anchoring the front end of the US Treasury curve (up to the seven-year point as an illustration) and repressing related volatility.


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With renewed purchases of securities and its willingness to extend the guidance language into 2015, the Fed can keep these rates artificially low for quite a while.



Long-maturity US Treasuries are a trickier proposition for the Fed. This favours a number of assets, including high quality short- and intermediate-maturity corporate bonds, agency mortgages, related sales of volatility and even some high-quality non-agency mortgages and structured products.


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It also supports hard assets, such as gold, where people go in an attempt to protect against the potential risk of higher inflation.




The temptation to extrapolate this argument to other risk markets is tempting. But investors should recognise that the Fed has much less control on prices in the equity and high-yield segments. Similarly, a differentiated analysis is warranted for currency positioning.



Here, fundamentals – whether domestic or international – can overwhelm the impact of Fed action. This is especially true in today’s global economy; one that is in a synchronised slowdown, gripped by an unusual level of political polarisation in Europe and the US and lacking any sustained cross-border policy coordination.



Technicals are also an issue. There are consequential differences among asset classes when it comes to the balance between traders and long-term investors.



Mr Bernanke’s speech should answer most questions on whether he is willing to lead his Fed colleagues deeper into experimental monetary policy. He is.



Yet in extrapolating the market impact, investors would be well advised to differentiate. Particularly in today’s extremely fluid global economy, there can be sudden lapses in some markets when it comes to mapping Mr Bernanke’s willingness to his effectiveness.



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Mohamed El-Erian is chief executive and co-chief investment officer of Pimco
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Copyright The Financial Times Limited 2012



Back-to-School Letter to the US Congress
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Mohamed A. El-Erian
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03 September 2012
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NEWPORT BEACHWhat if members of the United States Congress, now returning from their summer recess, were to receive a “back to schoolletter from concerned citizens? Here is what a first draft might look like.
 
 
 
Dear Member of Congress:
 
 
 
Welcome back to the Capitol. We hope that you had a good summer break, and that you return to Washington not just rested, but also energized to take on our country’s mounting economic challenges.
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The news has been mixed during your absence. We have seen some improvement in economic data, but not enough to suggest that we are any closer to overcoming decisively this painful period of low growth and high unemployment.


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And, with a self-inflicted fiscal cliff looming one that could send our country back into recession, pulling the rest of the world with us businesses are reluctant to hire and invest in new capital goods. Fortunately, the Federal Reserve has signaled its intention to remain active, but its policy tools are poorly suited to the challenges that we face.
 
 
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Meanwhile, global difficulties remain substantial. We continue to face strong headwinds originating from the deepening European debt crisis, as well as geopolitical tensions in the Middle East.


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China, once the world’s unstoppable growth engine, is slowing. And, despite all the happy talk, multilateral policy coordination is essentially non-existent.
 
 
 
All of this calls for courageous and visionary economic leadership; otherwise, our problems will fester and grow, and the solutions will become even more complex. Already, too many of our economy’s difficulties, including worrisome trends in youth joblessness and long-term unemployment, risk becoming structurally embedded.
 
 
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No doubt you have also noticed that, with less than ten weeks to go until the November presidential election, our country is in the grip of an increasingly ugly political campaign. So, with this combination of bad economics and bad politics, we look to you for direction and leadership. It is that simple, and that important.
 
 
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We need you to overcome a prolonged period of congressional paralysis and polarization in order to address the country’s malaise. We need you to pivot in your responses from the tactical to the strategic, from the cyclical to the secular, from the partial to the comprehensive, and from sequential to simultaneous reforms.
 
 
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If this call to national duty is not enough, we would remind you of your own self-interest. According to the latest NBC News/Wall Street Journal poll, your support among us, the electorate, stands at just 12%.
 
 
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We concede that there is no magic wand to overcome our country’s problems. After all, for too many years leading up to the global financial crisis, Americabought” and “borrowed” its growth by leveraging balance sheets, rather than “earningit through increased competitiveness. The result was massive misallocation of human resources, insufficient infrastructure investment, over-reliance on credit entitlements, and, of course, unsustainable debt. To make matters worse, this occurred at a time when systemically important emerging economies hit their “developmental breakout phase,” powered by trade and other aspects of globalization.
 
 
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We do not expect you to solve America’s problems overnight. Instead, we look to you to embark on an appropriate and sustainable policy path. So, as you unpack your bags and renew old friendships and rivalries, please keep the following in mind.


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Changing course requires that you, together with the president, have a much more open and consistent economic dialogue with us, the general public, about the challenges that we face. It also requires that you and the president converge on a multi-prong, multi-year policy initiative that, at a minimum, makes simultaneous advances in six critical areas:
 
 
 
- Fiscal reform: We desperately need you to eliminate the looming fiscal cliff in the context of medium-term reforms of both the tax system and entitlements. This would also allow for greater fiscal stimulus at a time when other components of aggregate demand are slowing.
 
 
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- Labor-market reform: Persistently high unemployment and large-scale withdrawal from the labor force are a constant reminder of a malfunctioning labor market that needs support through better training and retooling. Reform must also address the related challenges of a lagging education system and an insufficient social safety net.
 
 
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Housing and housing finance: At the root of the global financial crisis, the troubled US housing market continues to act as a millstone around the economy’s neck. The longer the problems persist, the greater the pressure on consumer and business sentiment, and the harder it is for the unemployed to find and relocate to new job opportunities.
 
 
 
- Clogged credit pipes: With banks’ balance sheets contracting, too many small and medium-size companies are unable to mobilize credit for investment and growth. Recognizing that it will take years until banks are properly stabilized, America needs to build new conduits for credit.
 
 
 
Infrastructure: Those of you who have traveled abroad know that our infrastructure is desperately lagging that of a growing number of countries. This makes it even harder for our companies to compete and prosper.
 
 
 
 - Global policy coordination: America’s traditional leadership role has evaporated in recent years as our problems have made us more insular and inward-looking. This would not be a major problem if the resulting vacuum had been filled. But that has not happened. On the contrary, the G-7 has lost relevance, the International Monetary Fund is hampered by its representation and legitimacy deficits, and the G-20 is still finding its feet.
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Engineering such an agenda is not an overwhelming challenge. But that will provide little comfort if you, our elected representatives, do not collaborate effectively.
 
 
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The choice Congress faces this term is simple: either address head on America’s challenges, or risk being remembered as the body whose dithering condemned future generations to being worse off than their parents.
 
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Yours sincerely,
 
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Concerned citizens



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Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment company PIMCO, with approximately $1.8 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, and 2011. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by the Economist.


September 3, 2012 8:26 pm
 
Eurozone: Convergence in reverse
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mario draghi©Reuters




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European economic convergence, that grand post-1945 vision of a borderless financial system, is starting to unravel. After decades of progress, banks are retrenching behind national borders.


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Businesses, consumers and governments in the south are facing dramatically higher borrowing costs than those in the north – in turn deepening recessions. The European Central Bank is replacing private cross-border capital on a large scale.




The disintegration of the eurozone’s financial system highlights how the benefits brought by the euro’s launch in 1999 – a crowning moment in the push to integrate the continent’s economies – are fading. It is causing alarm at the Frankfurt headquarters of the ECB. “If we want to get out of this crisis, we have to repair this financial fragmentation,” Mario Draghi, president, warned in July.



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The wild variations in borrowing costs show how the ECB has lost control over interest rates – the main weapon in a central bank’s armoury. Mr Draghi is worried about the destructive impact of eurozone break-up speculation on rates. On Thursday, the bank’s governing council will debate plans for intervention to regain control of interest rates in sovereign debt markets and calm the worst fears about Europe’s monetary union.


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Fragmentation is about much more than just monetary policy, however: The risk is that it will fuel public opposition to the euro in troubled economies and erode the arguments for membership – perhaps making a break-up more likely.



“We are making a mockery of the single market and closing down access to financial markets,” says Jean Pisani-Ferry, head of the Bruegel think-tank in Brussels. “Can it be reversed? We don’t know. We have not seen that so far. What we have seen, unfortunately, is a continuation of the process. The ECB is very rightly concerned.”



Until a few years ago, eurozone policy makers could hail the convergence of markets and economies in the bloc, now comprising 17 countries. Most striking was the narrowing of the “spread” between the interest rate demanded by investors on ultra-safe German bonds and those of other members. In November 2009, the yield on a Greek 10-year bond was less than 2 percentage points higher than on the German equivalent. It is now 22 percentage points.


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With hindsight, such convergence was not all positive. Low borrowing costs in the south encouraged credit and housing booms – and reckless fiscal policies in Greece.



Worried about a possible break-up, bond markets are now forcing weaker members to pay a heavy price. Foreign investors have pulled out of Spanish and Italian sovereign debt marketsleaving only domestic banks to buy new issues, using money borrowed from the ECB. Unsustainable borrowing costs and banking crises have pushed Greece, Portugal, Ireland and Cyprus into emergency bailout programmes – and Spain has asked for help for its banks.








Adding to the pain, banks have cut back on lending and cross-border exposure, pushing interest rates up further, especially for small- and medium-sized companies. A company borrowing less than €1m for up to five years can expect to pay an interest rate of 6.5 per cent in Spain, but just 4 per cent in Germany.



It is not just markets that are driving fragmentation. Banks face domestic pressure to reduce cross-border exposure. “Every national regulator is asking: ‘How can I reduce the risk of my banks being impaired if something goes wrong in the eurozone’. This ‘financial protectionism’ is not going to go away,” says Huw van Steenis of Morgan Stanley.


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The ECB estimates that since mid-2011, the share of cross-border credits in overnight money markets – which oil the financial system – has fallen from 60 per cent to less than 40 per cent. Speculation about the exit of individual crisis-hit countrieslinked with a devaluation – are massively influencing the interbank lending market,” Jörg Asmussen, an ECB board member, said last week.

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Fragmentation is having a “freezing impact” on corporate investment, says Mark Cliffe of ING. “If you are a large multinational, you are not going to be in a hurry to invest in the periphery. That’s one reason why companies are sitting on so much cash.”



As private cross-border capital flows have dried up, the ECB has expanded its supply of liquidity to eurozone banks. Spanish lenders are borrowing more than €400bn, equivalent to 11 per cent of total bank assets. For Italy, the figure is almost €300bn.



The result has been soaring imbalances on the Target 2 cross-border payments system used by eurozone central banks. Mirroring the southerly flow of ECB funds, Germany’s Bundesbank has Target 2 claims in excess of €700bn.
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The significance of such imbalances is hotly disputed among economists. Some, including those at the Bundesbank, argue they reflect an ECB response to the crisis and are not a guide to the bill a country would face in the event of a eurozone break-up.




Still, they have gained political significance. The ECB’s actions have “supercharged the politics because the liabilities have become socialised and it is the taxpayer who is on the hook”, argues Mr Cliffe. “If the monetary union breaks up, then the liabilities would crystallise and somebody has to pick up the bill.”


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Reversing the eurozone’s fragmentation will require encouraging financial flows back into the periphery countries – which in turn will require rebuilding confidence in the euro’s future. That is the challenge facing Mr Draghi and eurozone politicians in the days and weeks to come.



Additional reporting by Robin Wigglesworth


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Copyright The Financial Times Limited 2012.