June 4, 2013 6:27 pm

America owes a lot to Bernanke

by Martin Wolf

Ingram Pinn illustration of Uncle Sam and Ben Bernanke

Ingram Pinn illustration of Uncle Sam and Ben Bernanke©Ingram Pinn

It is easy to find people on Wall Street who believe that the aggressive monetary policies of central banks, particularly the US Federal Reserve’s quantitative easing, are destabilising the economy. In some quarters, as my colleagues Dan McCrum and Robin Harding have reported, this suspicion has been elevated to a self-evident truth. But it is wrong.

Central banks, including the Fed, are doing the right thing. If they had not acted as they have over the past six years, we would surely have suffered a second Great Depression. Avoiding such a meltdown and then helping economies recover is the job of central banks. My criticism, albeit more of the European Central Bank than of the Fed, is not that they have done too much, but that they have done too little. This does not mean that policies central banks have adopted are either riskless or costless. They are not. It does mean that they were the least bad option..

What is more, the fact that yields on bonds of highly rated sovereigns have risen recently is surely a sign of success. What seems to be happening is the rebirth of some confidence in the economy, particularly in the US. This is encouraging investors to expect an earlier exit from QE and other forms of expansionary monetary policy than was foreseen a few weeks ago.

As Gavyn Davies notes, this may be the start of a return to normality. Yes, yields on US conventional 10-year bonds are up about 40 basis points over the past month. But they are still just over 2 per cent. This is hardly a bond market Armageddon.

If recovery takes hold, as we hope, yields will rise further. Nobody can have supposed that nominal and real long-term interest rates would remain at basement levels forever.

Why are the criticisms of the Fed’s policies so wide of the mark? The answers are both philosophical and more narrowly economic.

The philosophical answer is that the central bank is a public institution charged with a public purpose. Its role is to stabilise the economy against financial upheaval. Some insist that the central bank bears sole responsibility for the turmoil. But the view of the late Hyman Minsky that the credit-driven financial system generates instability internally seems more plausible.

On the economic side, the financial crisis disrupted the creation of money, for which private institutions – the banks – are normally responsible. Huge attention has been paid to the expansion of the balance sheets of central banks. But far more important are the broader monetary aggregates, which measure money in the hands of the public. The growth of broad money depends on the willingness of banks to lend more. After the crisis, that vanished.

One can see this in the measure known as “divisia broad money” (see chart). The Center for Financial Stability in New York estimates that, on this measure, the money supply was just 0.7 per cent higher in April 2013 than it had been in October 2008despite the expansion of the Fed’s balance sheet. This is a monetary famine, not a feast.

The second economic answer is that the financial crisis coincided with falling real house prices in the US and triggered deleveraging among financial institutions and households. It took strong monetary and fiscal action to offset these contractionary forces. Since fiscal support was, alas, withdrawn prematurely, the burden fell on the Fed. With short-term interest rates at the zero bound, it had to influence longer-term rates if monetary policy was to gain traction.

Moreover, since US gross domestic product in the first quarter of 2013 was just 3.3 per cent higher than in the second quarter of 2008, it is easier to believe that the Fed has done too little than too much. Critics warned of imminent hyperinflation, but inflation expectations are under control, while core inflation in the year to 15 April 2013 was a mere 1.7 per cent. The risk of a collapse into Japanese-style deflation was greater.

Exceptional times call for exceptional measures. Those who criticise the Fed so bitterly either lack imagination or are indifferent to what would have happened to the economy and fellow citizens if the Fed (and other central banks) had sat on their hands. This does not mean that normalisation will be easy. The secular fall in bond yields may indeed be at an end. This is sure to create difficulties, particularly for leveraged investors.

The central bank now confronts at least three challenges. The first is how to execute its exit. This involves questions not just of timing, but of providing clarity about its plans in an inherently uncertain environment. In current circumstances, the key will be to avoid acting prematurely, so risking an aborted recovery.

The second challenge is dealing with uncertainty beyond policy makers’ control. One unknown is US fiscal policy. In testimony to Congress last month, Mr Bernanke noted that “the Congressional Budget Office estimates that the deficit reduction policies in current law will slow the pace of real GDP growth by about 1-1½ percentage points during 2013, relative to what it would have been otherwise”. This is troublesome. Equally out of his control are events in the eurozone, though it does look much less unstable than a year ago.

The third challenge is over the longer-term sources of demand. I look at this issue in terms of the sectoral financial balances – the balances between income and spending – in the household, business, external and government sectors. The question, then, is where expansion will come from. In the first quarter of this year the principal offset to fiscal contraction was the declining household surplus.

What is needed, as well, is a big swing towards surplus in the US current account or a jump in corporate investment, relative to retained profits. Neither seems imminent, though the second seems more likely than the first. The worry is that the only way to balance the economy will be via big new bubbles. If so, this is not the fault of the Fed. It is the fault of structural features of the domestic and global economies that shaped the pre-crisis excesses, hampered the recovery and threaten the sustainability of future growth.

Broadly speaking, the Fed has done the right thing in trying to bring the US and world economies through the crisis. It deserves praise. But the persistence of the global imbalances and the huge surpluses of the corporate sector will combine to make achieving a strong and sustained recovery difficult.

The central bank cannot fix such problems. It can only do what it can. In the US, at least, it has done so.

Copyright The Financial Times Limited 2013.

Following the Fed to 50% Flops

John Mauldin

Jun 04, 2013

John Hussman is one of the savviest investing minds I know, and so I never miss his Weekly Market Comment. This week he wrote about an interesting disconnect between what investors believe about "fighting the Fed" (i.e., don't do it) and the reality of S&P 500 returns, and I've made that piece today's Outside the Box.

John leads off with a provocative fact: "… the last two 50% market declines both the 2001-2002 plunge and the 2008-2009 plungeoccurred in environments of aggressive, persistent Federal Reserve easing." Go figure, right? And to make the situation even more counterintuitive and confusing,

the maximum drawdown of the S&P 500, confined to periods of favorable monetary conditions since 1940, would have been a 55% loss. This compares with a 33% loss during unfavorable monetary conditions. This is worth repeatingfavorable monetary conditions were associated with far deeper drawdowns.

So what gives? Hussman explains:

Part of the reason that monetary policy was so ineffective during 2001-2002 and 2008-2009 is that these market collapses were preceded by overvalued, overbought, overbullish euphoria, and then gave way to economic downturns. Though monetary policy certainly fed the preceding bubbles, monetary policy did not prevent or halt those recessions, and those recessions were not broadly recognized until stocks had already lost about 30% of their value.

Take heed!

Your dreaming of carpet samples analyst,

John Mauldin, Editor
Outside the Box

Following the Fed to 50% Flops

By John P. Hussman, Ph.D.

One of the most strongly held beliefs of investors here is the notion that it is inappropriate to “Fight the Fed” – reflecting the view that Federal Reserve easing is sufficient to keep stocks not only elevated, but rising. What’s baffling about this is that the last two 50% market declinesboth the 2001-2002 plunge and the 2008-2009 plungeoccurred in environments of aggressive, persistent Federal Reserve easing.

It’s certainly true that favorable monetary conditions are helpful for stocks, on average. But that average hides a lot of sins.

There are many ways to define monetary conditions using policy rates, market yields, and variables such as the monetary base or other aggregates. But given the strong relationship between monetary base/GDP and interest rates, these measures overlap quite a bit, and the results are quite general regardless of the precise definition. For discussion purposes, we’ll definefavorablemonetary conditions here as: either the Federal Funds rate, the Discount Rate, or the 3-month Treasury bill yield lower than 6 months prior, or the last move in the Fed Funds or Discount Rate being an easing. Historically, this captures about 52% of historical periods. During these periods, the total return of the S&P 500 averaged 13.5% annually, versus just 8.8% annually when monetary conditions were not favorable.

This is a worthwhile distinction, but it doesn’t partition the data enough to separate out periods where the average return on the S&P 500 was below Treasury bills. So historically, using this indicator alone would have suggested holding stocks regardless of monetary conditions.

One might expect to do better by taking a leveraged exposure during favorable monetary conditions, and a muted exposure during unfavorable conditions, but this strategy would have invited intolerable risks. Strikingly, the maximum drawdown of the S&P 500, confined to periods of favorable monetary conditions since 1940, would have been a 55% loss. This compares with a 33% loss during unfavorable monetary conditions. This is worth repeatingfavorable monetary conditions were associated with far deeper drawdowns.

If this all seems preposterous and counterintuitive, consider the last two market plunges. While investors seem to have forgotten this inconvenient history, the 2001-2002 market plunge went hand-in-hand with continuous and aggressive monetary easing.

Ditto for the 2008-2009 market plunge. Persistent monetary easing did nothing to prevent a 55% collapse in the S&P 500.

From an asset allocation perspective, even simple trend-following methods have performed far better historically than following monetary policy. For example, since 1940, when the S&P 500 has been above its 200-day moving average, the total return of the index has averaged 14.2% annually, versus just 4.5% when the index has been below its 200-day average. That separation in returns is meaningful, because the return during periods of unfavorable trends did not exceed Treasury bill returns, so it would not have harmed long-term performance to be out of the market during those periods (at least, before transaction costs, taxes and slippage). The deepest loss of the S&P 500, confined to periods of “favorabletrends and reflecting occasional whipsaws, was -26%, versus -53% during unfavorable trends.

As I noted a few weeks ago (see Aligning Investment Exposure with the Expected Return/Risk Profile), all of the net historical benefit of favorable trend-following has occurred in periods where “overvalued, overbought, overbullishcharacteristics have been absent. In the presence of this syndrome, the average total return of the S&P 500 collapses below Treasury bill yields, on average. The same is true, on average, when favorable monetary conditions are coupled with overvalued, overbought, overbullish features.

Hands-down, the worst-case scenario is a market that comes off of such overextended conditions and then breaks trend-support in the context of an economic downturn. That’s not something we observe at present, but it is something to keep in mind, as I doubt that we will avoid that sequence over the completion of the current market cycle.

Part of the reason that monetary policy was so ineffective during 2001-2002 and 2008-2009 is that these market collapses were preceded by overvalued, overbought, overbullish euphoria, and then gave way to economic downturns. Though monetary policy certainly fed the preceding bubbles, monetary policy did not prevent or halt those recessions, and those recessions were not broadly recognized until stocks had already lost about 30% of their value. At least in post-war data (Depression-era data is more challenging), the proper investment approach has generally been to accept market risk in the presence of favorable market action, particularly if monetary conditions are supportive, to start walking when overvalued, overbought, overbullish conditions emerge, and to run once momentum rolls over (as it has already).

There’s a grey area when such overextended conditions are cleared, which can allow for recovery rallies if market action is still supportive. But regardless of monetary policy, investors should avoid risk in richly-valued environments once market action deteriorates, and buckle up hard on signs of economic weakness once an overvalued market loses trend support.

The following point should not be missed. I am not saying that monetary conditions are unimportant. Indeed, provided that trend-following conditions are favorable and overvalued, overbought, overbullish conditions are absent, favorable monetary conditions have contributed to stronger total returns for the S&P 500, and reduced periodic losses, in data since 1940. Favorable monetary conditions are most useful in confirming and supporting favorable evidence on other measures. My concern here, however, is that investors seem to believe that favorable monetary conditions are a veto against all other possible risks, regardless of whether those risks are financial (e.g. overvalued, overbought, overbullish conditions) or economic. This is dangerously incorrect.

There is no question that Fed action can affect economic outcomes when it relaxes some economic constraint that is actually binding (for example, during bank runs, when Fed-provided liquidity is essential). But there is little evidence of any transmission mechanism whereby a greater supply of idle bank reserves promises to make a dent in the economy beyond occasional and short-lived can-kicks. There is also no question that interest rates matter, given that stocks must compete with bonds. But stocks are much longer duration securities than investors seem to appreciate, and the relationship between stock yields and interest rates is not even close to one-to-one, despite what Fed Model proponents might suggest.

Even so, investors have come to believe that there is a direct cause-and-effect link from monetary easing to rising security prices. The historical evidence is much less supportive.

Interestingly, if we look at conditions that have been most generally hostile for stocks on average (S&P 500 below its 200-day moving average, or overvalued, overbought, overbullish conditions in place), more than half of these periods were accompanied by “favorablemonetary conditions. Stocks proceeded to underperform Treasury bills anyway, on average, with steep interim losses.

Conversely, monetary conditions have been unfavorable in nearly half of historical periods where trends were supportive and overvalued, overbought, overbullish features were absent. In those periods, the average total return of the S&P 500 was still quite strong, and returns were only slightly lower tan when monetary conditions were favorable under otherwise similar conditions (15.6% vs. 18.9% at an annual rate), while periodic drawdowns increased only slightly.

So again, the point is not that favorable monetary conditions are irrelevant. The point is that they are not omnipotent – and that the most severe market losses on record have been accompanied by aggressive easing. Without question, quantitative easing has been very effective in suppressing spikes in risk premiums in recent years. More recently, it has been effective in removing any perception that stocks have risk and creating the impression that easy money is enough to override every possible economic or financial concern. But that is where perception has moved beyond reality. There is no evidence in the historical record for such optimism. Indeed, even the recovery from the 2009 lows was more directly linked to the change by the Financial Accounting Standards Board to eliminatemark-to-marketaccounting (keeping banks from insolvency even if they were technically insolvent) and the shift to an outright guarantee of Fannie Mae and Freddie Mac debt by the U.S. Treasury. It is superstition to believe that monetary easing is a panacea. Investors who recognize (actually, simply remember) this now are likely to fare better than those who are forced to relearn it later.

Needless to say, all of this will be summarily ignored by speculators who have been rewarded by the strategy of following the Fed in a mature, overvalued, overbought, overbullish, unfinished half-cycle that recently hit new highs. Advice from Kenny Rogers – you never count your money when you’re sittin’ at the table.

Economic Notes

We’re observing some very wide dispersion in regional economic surveys in recent reports. On one hand, the Chicago Purchasing Managers Index surged to 58.7 last month, with the important new orders component jumping to 58.1 (a level of 50 on the PMI is neutral). This sort of strength, if sustained over several months and joined by strength in the Philadelphia Fed index, would help to ease our economic concerns here, as several months of strength on these two measures are among the more reliable leading indicators of economic shifts.

On the other hand, in nearby Milwaukee, the PMI collapsed from 48.4 to 40.7, while the Philadelphia Fed index itself dropped into negative territory, falling from +1.3 to -5.2, with the new orders component deteriorating from -1.0 to -7.9. That general weakness was much more in line with what we’re observing from other surveys, including the Chicago Fed National Activity Index, Empire Manufacturing, Dallas Fed, and Richmond Fed.

When we plotoutliers” (where the Chicago PMI deviates from the average of the other surveys), against subsequent changes in the Chicago PMI, what results is a clearly downward-sloping scatter, meaning that positive outliers, as we presently observe, are typically corrected by subsequent disappointments in the Chicago PMI. Conversely, however, outliers in the Chicago PMI are typically not related to subsequent positive surprises in the other indices. Again, joint strength in the Chicago PMI New Orders component and the Philly Fed index, sustained over a period of 3-4 months, does tend to lead broader improvements. This is not what we observe here.

In short, the coincident and leading economic evidence is deteriorating, not improving. Even the chart below incorporates a strong Chicago PMI figure that appears to be a temporary outlier. Employment data is a well-known lagging indicator, and is always somewhatrear-view”, but it’s fair to say that given what is now the lowest labor participation rate in 30 years, the relatively restrained level of new claims for unemployment has been a bright spot.

It seems to be universally assumed that surprisingly strong data on the economic and jobs front would pose the greatest risk to the market, as it would accelerate the “taper” of quantitative easing. To the contrary, the largest risk here would be an acceleration of disappointing economic data, as it would further reinforce the case made by former Fed Chairman Paul Volcker that the benefits of quantitative easing are “limited and diminishing.” Disappointments on the economic front may be met with knee-jerk enthusiasm. But the quickest path to an extended bear market would be a deteriorating economy, coupled with recognition that quantitative easing has an even weaker benefit/cost tradeoff than is already plain.

Markets Insight

June 4, 2013 2:11 pm
Markets Insight: Bond market jitters strengthen case for the bears
When talk of ‘tapering’ has such an impact, good economic news is bad news

Can you hear the bears growling? When bonds and equities were rallying globally until recently, the bear argument was that central banks and regulators had created such worrying vulnerabilities in the financial system that a plunge back to earth was only a matter of time. That tipping point looks closer than we thought a month ago.

Hints by Ben Bernanke, US Federal Reserve chairman, about a possibletapering” of the Federal Reserve’s quantitative easing programme two weeks ago not only drove up US bond yields, which move inversely with prices, and caused significant losses for bond investors; they created upsets globally.

Depending on your choice of measure, volatility in US Treasuries has jumped to levels not seen for a year and has also spiked for German Bunds. In Japan, where the central bank has struggled to control yields, volatility is back at levels last seen in 2008 and share prices are yo-yoing.

Such instability is a concern because low and stable core bond yields were the basis of the “carry trades” – borrowing at low interest rates to pile into higher yielding assets – that spurred stock and bond market advances.

What matters now is whether the pattern morphs into a disruptive sell-off – or the recalibration needed to prevent the bear scenario becoming reality.

The bull case for not worrying yet is that the Fed will act to prevent disorderly market shifts, wary of the possible impact on a still-nascent US economic recovery. Also arguing against this being a turning point is that exceptional central bank support for economies will be in place for a lot longer. The Bank of Japan has only just launched its aggressive bond buying plans; the European Central Bank could yet embark on asset purchases or fresh, large-scale liquidity injections.

But pessimists argue that if the mere talk about a “tapering” can cause such trouble, the probability of bigger accidents in coming months is substantial. In a topsy-turvy world in which good economic news is bad news – because it brings forward the day when QE stopsstrong non-farm US payroll data on Friday could see further disruptive bond selling.

Jaime Caruana, general manager of the Bank for International Settlements, on Tuesday highlighted the extraordinary challenge facing central bankers in a speech in Korea. Monetary authorities not only had to manage expectations about short-term interest rates, he argued. They also faced the “unfamiliar” (note the central banker’s understatement) challenge of managing longer-term interest rates, driven down by asset-purchase programmes to a point where investors pay a penalty for holding on to fixed-rate bonds.

“The very success of pushing the term premium down into negative territory has created the risks of a sudden rise, even if central banks succeed in communicating their intended paths for short-term policy rates,” Mr Caruana warned.

What is striking about the past few weeks is how global bond markets have moved in sync, despite differences in economic fundamentals. Measuring correlations is hard. But Ramin Nakisa and Stephane Deo, strategists at UBS, have broken up shifts in yield curves into different typesup and down moves in the whole curve, or a steepening or flattening, for instance. Their results suggest that correlations between US, UK, German and Australian yield curves have indeed strengthened significantly. In other words, we could be back on a scary rollercoaster of “risk-on, risk offmarket movements.

As the UBS researchers point out, there are historical precedents. In 1994 Germany’s Bundesbank cut official interest rates but the Fed had started a tightening cycle, and German yields went up, with the Bundesbank controlling only the very short end of the curve.

The truth is that we know relatively little about how central bank actions have affected global financial flows and priceslet alone, how the process will work in reverse. Speaking at the same conference as Mr Caruana in Korea, Benoît Cœuré, ECB executive board member, argued the debatefocuses too much ... on the negative externalities of domestic monetary policy decisions” and that better economic growth and deeper financial markets had also spurred investment in emerging market economies.

But even if the central banks’ impact on flows has been modest, quantitative easing has artificially lifted asset prices globally. Some protection against contagion effects may be offered by increased financialfragmentation” – the withdrawing by banks behind national borders.

That seems the case so far in eurozone periphery bond markets, from which nervous foreign investors have already fled. But fragmentation and tougher regulation may also have created bottle necks in the financial system, so it will be harder to find buyers in a downturn, and panic reactions could ensue. It’s the bears versus central bankers.

Copyright The Financial Times Limited 2013