viernes, septiembre 21, 2012



Ben buys, bulls buoyant

How asset prices react to quantitative easing

Sep 22nd 2012


LIKE Pavlov’s dogs, stockmarkets responded to the latest round of quantitative easing (QE) by the Federal Reserve by salivating over the juicy rewards ahead. With the European Central Bank primed to act, and the Bank of Japan (BoJ) beefing up its asset-purchase fund on September 19th, it seems as if equity analysts should give up forecasting corporate profits and concentrate on decoding hints from central bankers.

How sound is this latest rally? Research by Morgan Stanley shows that previous rounds of monetary stimulus have had the effect of boosting the valuation of the stockmarket (a higher price-earnings ratio) without boosting profits (as measured by earnings per share). In addition, QE has boosted investor sentiment. So one interpretation of the evidence is that QE results in what Fredrik Nerbrand of HSBC describes as a “sugar high”—a rush of blood that does little for long-term economic growth.


However, analysts may be underestimating the economic benefits of QE. It is impossible to know what things would have looked like without the previous rounds of monetary stimulus. And even if QE has no effect on economic growth, it may still be rational for investors to buy equities. That is because Ben Bernanke, the Fed’s chairman, also signalled that interest rates would be kept at their current ultra-low levels until 2015. Such low rates will also keep a lid on short-term bond yields. So investors will be pushed out of low-risk assets and into the stockmarket.

Charles MacKinnon of Thurleigh Investment Managers also argues that shares in global firms with a diversified profits base are an attractive asset class in an era when governments are generally trying to reduce the value of their currencies. The BoJ’s action this week is widely seen as an attempt to weaken the yen.

The other asset class to benefit from previous rounds of QE has been commodities. This seems rational. If investors think QE helps economic growth, then demand for commodities should rise.

Low interest rates reduce the opportunity cost of holding non-yielding assets such as gold. And investors may perceive that QE increases the long-term risks of inflation, which also makes some commodities more attractive.

If you look at the data on inflation expectations, there are few signs of alarm. But a recent paper* from the Bank of England shows a greater level of uncertainty about the inflation outlook (as measured by the options market) than was the case three or four years ago.

Such uncertainty is perfectly understandable. After all, QE on this scale has never been tried before. There are three possible outcomes. One is that the economy remains stagnant with inflation low, as in Japan; the right strategy in those circumstances would be to buy government bonds. Another is that the economy recovers to pre-crisis growth levels; the right strategy then would be to buy equities.

The third possibility is that inflation accelerates rapidly as central banks lose control; in that case, buy commodities, especially gold. Investors have to hedge their bets against all three outcomes, which explains the apparently contradictory combination of rising equity and commodity prices, along with low bond yields.

But how long will those low bond yields last? The ten-year Treasury-bond yield has edged up to 1.8% from July’s low of 1.4%, and German ten-year yields have risen from 1.2% in July to 1.7%. There is a technical explanation for both moves. The Fed’s latest round of QE focuses on mortgage-backed securities rather than government bonds. And the ECB may have brought Europe one step closer to debt mutualisation, prompting a narrowing of the spread between the borrowing costs of Germany and the periphery.

Higher bond yields are a mixed blessing. To some extent they are an indication that investors are less nervous about the possibility of a double-dip recession. But if they increase too far, they will act to tighten monetary policy. Pushing bond yields down, not up, was the original justification for QE. Bolstering share prices was supposed to be only a side-effect.

* “Option-implied probability distributions for future inflation”, Quarterly Bulletin, Q3 2012

Introducing the “reverse Volcker moment”

Mohamed El-Erian

September 20, 2012

Is the US experiencing a “reverse Volcker moment” in which low and stable inflation gets subordinated to other economic objectives? Markets seems to hint this and an increasing number of central banks in the rest of the world appear concerned about it.

It is now over 30 years since Paul Volcker came into the US Federal Reserve and unambiguously put crushing inflation at the top of his agenda. What followed was a period of price stability – by the middle of the last decade, many people had bought into the concept of “the great moderation” and the “Goldilockseconomy (not too hot, not too cold).

The 2008 global financial crisis did little to alter the perception that inflation had been conquered. Indeed, the price challenge at that time was not too much high inflation but rather, a real threat of a disorderly decline in the general price level.

This may now be in the process of changing. There is a growing sense among some that today’s Fed would not only tolerate higher inflation but may also be wishing it – if not already targeting it.

The immediate catalyst is, of course, the central bank’s recent actions and statements. Four merit particular mention: the extension to mid-2015 of the forward guidance language on rock-bottom interest rates; the further ballooning of the Fed’s balance sheets through the commitment to open-ended purchases of securities; clear signals that such an unprecedented expansionary monetary policy stance will continue well into the economic recovery; and, related to all this, a subtle evolution of the official inflation narrative;

There certainly are legitimate and sensible reasons for a change in the Fed’s ranking of the components of its dual mandate: by placing employment well above inflation. Joblessness is stubbornly high, and has been so for far too long. As this situation persists, and it hits more disproportionately the young and the long-term unemployed (as is the case today), the greater the risk that this horrid crisis will get deeply embedded in the structure of the economy.

It also helps that many feel it is virtually impossible for the US to experience high inflation in the context of such large spare capacity.

America’s debt is another reason. It is not easy to safely deleverage a highly-indebted economy – and I stress safely – when growth is so sluggish

Financial repression, the technical term for the manner in which the Fed suppresses interest rates so that creditors de facto subsidise debtors, can help. But it is not enough. With the political process hindering meaningful reforms and refusing to sensibly allocating principal losses, the temptation to resort to “somewhat higher inflation is unquestionably there.

An important and consequential question is how the system would respond, nationally and globally.
Already, financial markets are starting to notice. Just witness the 25 basis point surge in break evens in the hours following the Fed’s QE3 announcement on Thursday last week, representing a5-sigma event for this market-measure of inflationary expectations.
Then there is the reaction of other countries. An increasing number of central banks, be it Brazil’s recent market interventions or Wednesday’s surprise announcement of additional Japanese balance sheet expansion, are being forced into a more expansionary monetary policies. Their intention is clear. They wish to counter the collateral damage emanating from the fed’s unconventional policies – from potentially destabilising surges in capital inflows to currency appreciation that erodes competitiveness.

These may be leading indicators of a global economy that is slowly starting to sense that, as my colleague Bill Gross recently put it, we may be entering an age of higher inflation. Having so decisively been eradicated from the collective psyche of Americans more generally, it will take time for society as a whole to adjust to the real possibility of both higher and less stable inflation over the medium term.

The average American does not worry much today about inflation judging from the allocation of their investment and retirement assets, price setting, and how wage settlements are negotiated. This could well be on the verge of evolving if the Fed is indeed in the midst of engineering a reverse Volcker moment.

09/20/2012 05:14 PM
Bailout Fund
Euro Zone Changing ESM to Satisfy German Court

By Stefan Kaiser and Christian Rickens

   The European Parliament building in Brussels: Euro-zone member states have agreed to a    declaration that will allow the permanent bailout fund to start its work soon.

The final hurdle may now have been cleared for the implementation of the European Stability Mechanism, the permanent euro bailout fund. Euro-zone member states appear to have reached an agreement on a legally binding statement that addresses the conditions stipulated by Germany's highest court before the ESM Treaty can be ratified.


It appears increasingly probable that the permanent euro bailout fund, the European Stability Mechanism (ESM), will be able to start its work in just a few weeks time. Last week, Germany's Federal Constitutional Court gave its green light for the ratification of the ESM Treaty, but it attached some conditions. SPIEGEL ONLINE has learned from government sources that European Union ambassadors of the 17 euro-zone member states plan to sign a so-called "interpretive declaration" in Brussels next Wednesday agreed to last week by the currency union's finance ministers.

The declaration is to clarify that the upper ceiling for a nation's liability established in the treaty can only be exceeded with the permission of that country's parliament. The declaration will also strengthen the rights of parliaments in obtaining information from ESM.

With the declaration, euro-zone states plan to address the central conditions set by the German high court on Sept. 12 to allow Germany to ratify the treaty. The court rejected injunctions against ratification of the ESM treaty, but they nevertheless demanded clarification on two points:

  • Without the authorization of Germany's federal parliament, the Bundestag, the country's cap for liability cannot exceed €190 billion ($246 billion), even if there are other possible interpretations of the ESM Treaty's language.

  • Assurances must also be given that professional secrecy requirements of ESM board members and employees will not interfere with German parliament's right to information.

Both of these points have now been addressed in the declaration that has been negotiated, a draft of which has been obtained by SPIEGEL ONLINE. "No provision of the Treaty may be interpreted as leading to payment obligations higher than the portion of the authorized capital stock corresponding to each ESM Member," it states. At least not "without prior agreement of each Member's representative and due regard to national procedures." In the case of Germany, this means that the upper ceiling of €190 billion cannot be exceeded without prior permission from parliament.

The declaration also speaks to the second concern identified by the German high court. Professional secrecy requirements in the ESM treaty shall not "prevent providing comprehensive information to the national parliaments, as foreseen by national regulation," it says.

Berlin government sources told SPIEGEL ONLINE that the language of the declaration has already been largely agreed to by ESM member states. But it still needs to be agreed to by national governments before it is officially signed next week. In Germany, this approval is expected to be provided during a meeting of Chancellor Angela Merkel's cabinet next Wednesday, just prior to the official signing in Brussels. A diplomat in Brussels added, however, that last-minute changes to the language could not be ruled out.

Under the preliminary plans, the ESM is expected to go into operation on October 8, with a lending capacity for crisis-plagued euro-zone countries of up to €500 billion ($647 billion). It will ultimately replace the current temporary bailout program, the European Financial Stability Facility.

China and Japan

Could Asia really go to war over these?

The bickering over islands is a serious threat to the region’s peace and prosperity

Sep 22nd 2012

THE countries of Asia do not exactly see the world in a grain of sand, but they have identified grave threats to the national interest in the tiny outcrops and shoals scattered off their coasts. The summer has seen a succession of maritime disputes involving China, Japan, South Korea, Vietnam, Taiwan and the Philippines. This week there were more anti-Japanese riots in cities across China because of a dispute over a group of uninhabited islands known to the Japanese as the Senkakus and to the Chinese as the Diaoyus. Toyota and Honda closed down their factories. Amid heated rhetoric on both sides, one Chinese newspaper has helpfully suggested skipping the pointless diplomacy and moving straight to the main course by serving up Japan with an atom bomb.

That, thank goodness, is grotesque hyperbole: the government in Beijing is belatedly trying to play down the dispute, aware of the economic interests in keeping the peace. Which all sounds very rational, until you consider history—especially the parallel between China’s rise and that of imperial Germany over a century ago. Back then nobody in Europe had an economic interest in conflict; but Germany felt that the world was too slow to accommodate its growing power, and crude, irrational passions like nationalism took hold. China is re-emerging after what it sees as 150 years of humiliation, surrounded by anxious neighbours, many of them allied to America. In that context, disputes about clumps of rock could become as significant as the assassination of an archduke.
One mountain, two tigers

Optimists point out that the latest scuffle is mainly a piece of political theatre—the product of elections in Japan and a leadership transition in China. The Senkakus row has boiled over now because the Japanese government is buying some of the islands from a private Japanese owner. The aim was to keep them out of the mischievous hands of Tokyo’s China-bashing governor, who wanted to buy them himself.

China, though, was affronted. It strengthened its own claim and repeatedly sent patrol boats to encroach on Japanese waters. That bolstered the leadership’s image, just before Xi Jinping takes over.

More generally, argue the optimists, Asia is too busy making money to have time for making war. China is now Japan’s biggest trading partner. Chinese tourists flock to Tokyo to snap up bags and designer dresses on display in the shop windows on Omotesando. China is not interested in territorial expansion. Anyway, the Chinese government has enough problems at home: why would it look for trouble abroad?

Asia does indeed have reasons to keep relations good, and this latest squabble will probably die down, just as others have in the past. But each time an island row flares up, attitudes harden and trust erodes. Two years ago, when Japan arrested the skipper of a Chinese fishing boat for ramming a vessel just off the islands, it detected retaliation when China blocked the sale of rare earths essential to Japanese industry.

Growing nationalism in Asia, especially China, aggravates the threat). Whatever the legality of Japan’s claim to the islands, its roots lie in brutal empire-building. The media of all countries play on prejudice that has often been inculcated in schools. Having helped create nationalism and exploited it when it suited them, China’s leaders now face vitriolic criticism if they do not fight their country’s corner. A recent poll suggested that just over half of China’s citizens thought the next few years would see a “military dispute” with Japan.

The islands matter, therefore, less because of fishing, oil or gas than as counters in the high-stakes game for Asia’s future. Every incident, however small, risks setting a precedent. Japan, Vietnam and the Philippines fear that if they make concessions, China will sense weakness and prepare the next demand. China fears that if it fails to press its case, America and others will conclude that they are free to scheme against it.

Co-operation and deterrence

Asia’s inability to deal with the islands raises doubts about how it would cope with a genuine crisis, on the Korean peninsula, say, or across the Strait of Taiwan. China’s growing taste for throwing its weight around feeds deep-seated insecurities about the way it will behave as a dominant power. And the tendency for the slightest tiff to escalate into a full-blown row presents problems for America, which both aims to reassure China that it welcomes its rise, and also uses the threat of military force to guarantee that the Pacific is worthy of the name.

Some of the solutions will take a generation. Asian politicians have to start defanging the nationalist serpents they have nursed; honest textbooks would help a lot. For decades to come, China’s rise will be the main focus of American foreign policy. Barack Obama’spivot” towards Asia is a useful start in showing America’s commitment to its allies. But China needs reassuring that, rather than seeking to contain it as Britain did 19th-century Germany, America wants a responsible China to realise its potential as a world power. A crudely political WTO complaint will add to Chinese worries).

Given the tensions over the islands (and Asia’s irreconcilable versions of history), three immediate safeguards are needed. One is to limit the scope for mishaps to escalate into crises. A collision at sea would be less awkward if a code of conduct set out how vessels should behave and what to do after an accident.

Governments would find it easier to work together in emergencies if they routinely worked together in regional bodies. Yet, Asia’s many talking shops lack clout because no country has been ready to cede authority to them.

A second safeguard is to rediscover ways to shelve disputes over sovereignty, without prejudice. The incoming President Xi should look at the success of his predecessor, Hu Jintao, who put the “Taiwan issue” to one side. With the Senkakus (which Taiwan also claims), both Mao Zedong and Deng Xiaoping were happy to leave sovereignty to a later generation to decide. That makes even more sense if the islands’ resources are worth something: even state-owned companies would hesitate to put their oil platforms at risk of a military strike. Once sovereignty claims have been shelved, countries can start to share out the resources—or better still, declare the islands and their waters a marine nature reserve.

But not everything can be solved by co-operation, and so the third safeguard is to bolster deterrence. With the Senkakus, America has been unambiguous: although it takes no position on sovereignty, they are administered by Japan and hence fall under its protection. This has enhanced stability, because America will use its diplomatic prestige to stop the dispute escalating and China knows it cannot invade. Mr Obama’s commitment to other Asian islands, however, is unclear.

The role of China is even more central. Its leaders insist that its growing power represents no threat to its neighbours. They also claim to understand history.

A century ago in Europe, years of peace and globalisation tempted leaders into thinking that they could afford to play with nationalist fires without the risk of conflagration. After this summer, Mr Xi and his neighbours need to grasp how much damage the islands are in fact causing. Asia needs to escape from a descent into corrosive mistrust. What better way for China to show that it is sincere about its peaceful rise than to take the lead?

September 20, 2012 7:25 pm
Beware the costs and psychology of QE3

Earlier this month, America’s Duke University asked the chief financial officers of 887 large companies how they might respond to falling interest rates. The results were noteworthy for economists, political pundits and investors alike.

Some 91 per cent of firms said a one per cent fall in interest rates would have no impact on their business plans, while 84 per cent professed indifference towards even a two per cent fall. CFOs believe that a monetary action would not be particularly effective,” the survey concluded; or not, that is, in terms of boosting investment and jobs.

This is sobering stuff. When Ben Bernanke, Fed chairman, unveiled his QE3measures last week – a promise to buy more mortgage-backed securities as part of quantitative easing – he justified this by pointing to the continued high levels of unemployment and weak growth. Most notably, by providing an open-ended commitment to buy securities, the Fed hopes to bolster demand and thus create more jobs.

Many observers (like my colleague Martin Wolf), would argue this is the right course to take. After all, as a senior official in Washington pointed out to me last week, the lesson of financial crises in recent years is that it pays to do more, not less, than appears necessary when faced with big headwinds. Nobody wants to repeat the mistakes of the 1930sliquidationists”, or 1990s Japan. And partly because of that, the Fed announced last week that 11 of the 12 voting members of the Fed committee backed Bernanke’s move.

But what the Fed did not reveal was that while almost all of the voting committee members supported QE3, several non-voting members did not (under the Federal system, the regional presidents vote on a rotating basis.) Indeed, if you include those non-voting members, around a third of the committee was wary, if not unhappy, with QE3.

And that was not just because of fears that the timing of QE3 looked “political”. The bigger worry is that the benefits of QE3 are so unclear, because the transmission mechanism is so muddled, while the potential costs are so high. “Anything that the Fed does is going to only have temporary effects,” James Bullard, head of the St Louis Regional Fed told Reuters earlier this week. Or as Richard Fisher, head of the Dallas Fed, observed in a powerful speech on Wednesday (which cited the Duke survey): “Nobody on the [Fed] committee . . . really knows what is holding back the economy.


Nobody really knows what will work to get the economy back on course. The very people we wish to stoke consumption and final demand by creating jobs and expanding business fixed investment are not responding to our [Fed] policy initiatives as well as theory might suggest.”

Now optimists might retort that this last point about company sentiment is not so important. After all, the fact that the Fed decided to buy MBS, rather than Treasuries, say, suggests that the consumer, not CFO, is the main target.

Notably, by lowering mortgage costs, and raising stock markets, these extraordinary measures have the potential to make consumers feel considerably happier. And that might actually be more important for economic growth than anything CFOs say. After all, the boom in corporate profits that occurred in recent years has not had muchtrickle downimpact on consumers.

In any case, optimists add, QE3 also provides a wider general psychological boost. As such, it might help offset the other downward drags on the economy, such as uncertainty about the looming USfiscal cliff or anxiety about China and the eurozone. On that last issue, it is worth noting that the US Treasury and White House are now steeling themselves for another three to five years of grinding uncertainty and possible volatility in the eurozone, irrespective of the recent, slight improvement eurozone news. Or, to put it another way, even if QE3 is not working through the conventional monetary transmission channels, it can stillwork” in other ways, by acting as foam on the runway to soften bumpy economic landings.

The crucial problem, as Fisher noted with such unusual clarity this week, is that the psychology of this is still so uncertain. With anything between $2,000bn and $4,000bn of unused liquidity now swirling around the US financial system (depending on how you measure it), consumers and CFOs alike can sense that monetary policy is becoming less effective. And yet, the more the Fed announces unconventional moves, the more stock market investors appear to demand additional drama. With every new round of QE, expectations and fears are being ratcheted up, in equal measure.

That is not reassuring in any sense. Anyone who feels tempted to start celebrating the recent share price rally, in other words, would do well to read Fisher’s bold speech – and then take a long, deep breath.

Copyright The Financial Times Limited 2012.