Things That Make You Go Hmmm...

A Barrel of Monkeys

By Grant Williams

September 3, 2013

"If you look at the monkeys, you can learn many things about the men; if you look at the men, you can learn many things about the madness!"

– Mehmet Murat ildan

"He didn't know what was defeating him, but he sensed it was something he could not cope with, something that was far beyond his power to control or even at this point in time comprehend."

– Hubert Selby, Jr., Requiem for a Dream

"He seemed unaware of the messiness of the arrangement."

– J.D. Salinger, Franny and Zooey

"Manipulation, fueled with good intent, can be a blessing. But when used wickedly, it is the beginning of a magician's karmic calamity."

– T.F. Hodge, From Within I Rise...

"How be caught up in a game and have no idea of the rules."

– Caroline Stevermer, Sorcery & Cecelia or The Enchanted Chocolate Pot

"What's more fun than a Barrel of Monkeys? Nothing!"

Not my words, but those of the Milton Bradley Co., which still produces under license a game first created by a gentleman named Leonard Marks, who sold the rights to his simple but addictive game to Lakeside Toys in 1965.

It would be difficult to imagine a simpler premise for a game than that of Barrel of Monkeys. The rules of the game, printed on the bottom of the plastic barrel in which the monkeys are contained, are simplicity itself:

Dump monkeys onto table. Pick up one monkey by an arm. Hook other arm through a second monkey's arm. Continue making a chain. Your turn is over when a monkey is dropped.


Each barrel contains 12 monkeys but can accommodate, at a push, 24, which makes the game so much more enjoyable. What could be better than assembling a long chain of tangled monkeys, each reliant on those either side of it for purchase, with just the one person holding onto a single monkey's arm at the top end of the chain, responsible for all those monkeys dangling from his fingers.

Of course, with great power comes great responsibility; and that lone hand at the top of the chain of monkeys has to be carefulany slight mistake and the monkeys will tumble, and that, I am afraid, is the end of your turn. You don't get to go again because you screwed it up and the monkeys came crashing down.

On May 22nd of this year, Ben Bernanke's game of Barrel of Monkeys was in full swing. It had been his turn for several years, and he looked as though he'd be picking up monkeys for a long time to come. The chain of monkeys hanging from his hand was so long that he had no real idea where it ended.

That day, in prepared testimony before the Joint Economic Committee of Congress in Washington, DC, Bernanke stated that the Fed could increase or decrease its asset purchases depending on the weakness or strength of data:

The program relates the flow of asset purchases to the economic outlook. As the economic outlook — and particularly the outlook for the labor marketimproves in a real and sustainable way, the committee will gradually reduce the flow of purchases.

To assuage any lingering doubt, he continued:

I want to be very clear that a step to reduce the flow of purchases would not be an automatic, mechanistic process of ending the program. Rather, any change in the flow of purchases would depend on the incoming data and our assessment of how the labor market and inflation are evolving.

Markets fluttered a little as they tend to do around these carefully stage-managed performances, but remained largely sanguine. However, in the Q&A session that followed his prepared remarks, Bernanke, in response to a fairly innocuous question, went a little off-piste, straying into some improv, making a suggestion that, within minutes, had given rise to a phenomenon which by the end of the day had earned its very own soubriquet: the "Taper Tantrum":

If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases. If we do that it would not mean that we are automatically aiming towards a complete wind down. Rather we would be looking beyond that to see how the economy evolves and we could either raise or lower our pace of purchases going forward.

The statement contained the usual bit about the Fed being open to both decreasing OR increasing bond purchases; but it added one, as it turned out vital, piece of information:

"... we could in the next few meetings ... take a step down in our pace of purchases."

Boom! That's all it took. The monkeys began to shiver, shake, and screech.

Now, I have been saying for the longest time that these days nothing matters to anybody until it matters to everybody, and that is largely down to the Fed themselves (and their peers across the various oceans and borders who are complicit in this era of free money). The proof of my statement is seen in the fact that as soon as Bernanke mentioned that the "taper" — which, let's face it, EVERYBODY knows has to happen sooner or later — would possibly begin before the end of 2013, markets began to crumble.

The S&P 500 dropped a quick 6% on the outlandish idea that free money by the trillion wasn't going to continue forever, and this came as something of a shock to investors who had watched the index levitate relentlessly as the stimulus being applied by the Fed to the tune of $85bn a month did its job — and by "did its job" I wish I were talking about lowering unemployment and stimulating growth; but, alas, I'm talking about bolstering bank balance sheets and driving equity prices to unsustainable and unfairly valued levels.

As you can see from the chart below, the market turned around and recovered its losses pretty quickly as a seemingly endless procession of Fed governors and "friendly" journalists were rolled out to explain — in increasingly panicked tones — that everything was OK and that the esteemed Chairman didn't actually say they would definitely be cutting off the easy money.
Source: Bloomberg

In his own prepared remarks the following morning, Fed mouthpiece and Wall Street Journal reporter Jon Hilsenrath was quick to soothe:

(WSJ): The next step by the Fed could be especially tricky. One worry at the central bank is that a single small step to shrink the size of the program could be interpreted by investors as the first in a larger move to end it altogether. [Yesterday] Mr. Bernanke sought to dispel that view, part of a broader effort by Fed officials to manage market expectations.

If the Fed takes one step to reduce the bond buying, it won't mean the Fed is "automatically aiming towards a complete wind-down," Mr. Bernanke said. "Rather we would be looking beyond that to seeing how the economy evolves and we could either raise or lower our pace of purchases going forward. Again that is dependent on the data," he said.

It's OK, folks. Ben's got this. Calm down.

After the scrambling was over and the 6% air pocket was safely navigated, the S&P 500 first regained and then surpassed its previous high. At this point, the Punditocracy (as my buddy Scott calls it) declared that any "taper" had now been priced in.

And there the story should have ended. Nothing to see here folks, get back to your couches.

But of course it didn't end.

It was Hilsenrath who had first floated the idea of a withdrawal of stimulus, before the term taper appeared (quite coincidentally, we may be sure) in Bernanke's remarks a few days later. On May 11th he wrote:

(WSJ): Federal Reserve officials have mapped out a strategy for winding down an unprecedented $85 billion-a-month bond-buying program meant to spur the economyan effort to preserve flexibility and manage highly unpredictable market expectations.

Officials say they plan to reduce the amount of bonds they buy in careful and potentially halting steps, varying their purchases as their confidence about the job market and inflation evolves. The timing on when to start is still being debated.

At the time, Scotiabank published a nonexhaustive list of reasons why they believed it would make sense that the Fed might want to leak hints of an impending taper, and the list began with this little nugget:

(Zerohedge): 1) On Monday morning of this week, the RBNZ (New Zealand) and BoK (Korea) intervened in the currency market to try to dull the strength of their currencies. Soon afterward, Sweden and Chile announced they might have to intervene as well. Poland cuts rates to weaken the Zloty.

These actions and comments show that the external ramifications of QE will no longer be tolerated passively. These moves represent a tacit protest against QE. It could be argued that if QE policies do not subside soon, other governments are now willing to retaliate with counter-measures (currency wars, "a race to the bottom", protectionism).

Ah yesthose pesky "other countries".

Forgotten in the localized euphoria over the S&P's remarkable resilience was the fact that we live in an ever-shrinking world and that there are lots of other monkeys on the long chain dangling from Bernanke's hand. Moves the Federal Reserve makes have repercussions far and wide.

Like in Jakarta, for example.

After Bernanke's off-the-cuff remarks, the Jakarta Composite Index — like the S&P 500 — began to tumble. Only, unlike the S&P, it kept on falling after its counterparts in the USA bounced.

And then it fell some more.

As fears of an early taper swirled around the markets, the strength of the dollar caused foreign capital to flee Indonesia, and the rupiah collapsed, sparking fears of a replay of the Asian currency crisis of 1997-98, which began in similar circumstances when the Thai baht tumbled.

Over the month of August, the slide in the Indonesian equity market was exacerbated by the steepening fall of the rupiah, as the chart below shows.

Amidst all the commentary in the USA concerning the resilience of the S&P 500, Indonesia's slide was little noted.

Source: Bloomberg

Currently, in USD terms, the JCI has fallen 30% since May 22.

In an interview with CNBC, Indonesia's Finance Minister, Chatib Basri, explained that everything was OK and that there was absolutely no chance of capital controls being introduced:

(CNBC): Despite the exodus of foreign capital from Indonesia that has sent its currency tumbling in the recent weeks, Finance Minister Chatib Basri says Southeast Asia's largest economy is not in a state of crisis.

Basri told CNBC on Thursday that the country "has no intention" of implementing capital controls to stem the plunge in its currency, and is "not at all" in need of a bailout package as seen in 1997.

"We do not have any intention to use capital controls," he said. When asked whether the country has been in talks with the International Monetary Fund regarding a possible bailout, he said, "Not at all. The budget deficit will come in at about 2.4 percent of GDP, but the realization of the deficit until July was only 1 percent. There's still fiscal space."

Note that, technically speaking, what he actually said was that they had no intention of introducing capital controls.

Bookmark that one, folks.

The CNBC anchor then followed up with this question:

Can you categorically say to us that we are not going to see a repeat of what happened in 1997 with the Asian Crisis?

Basri was unequivocal in his answer:


And had he stopped there, things would have been fine — but he continued:

"I ... I'm pretty sure about it because the situation is quite different."

This chart of the Indonesian rupiah, courtesy of my friend Greg Weldon, shows just how quickly emerging-market currencies can move when there is a race to own US dollars:

Indonesian%20Rupiah.psd Source: Greg Weldon

Sigh... But wait ... there's more!

It's not just Indonesia that is scrambling in the dash for dollars in expectation of tapering by Bernanke's Fed.

The Philippines, one of the best-performing equity markets in the world during the first five months of the year, also suddenly turned ice-cold after May 22, as you can see from the chart below:

Source: Bloomberg

The PCOMP Index has recovered from its lows but has fallen an alarming 25% since May 22 in dollar terms. Once again it was capital outflows that did the damage; and, of course, the genesis of those outflows was our old friend in the Marriner S. Eccles Building, Ben Bernanke:

(Bloomberg): The PSE index has fallen 14 percent this month, poised for the steepest loss since October 2008, amid concerns that reduced U.S. Federal Reserve stimulus will spur capital outflows and local protests over discretionary government budgets will slow state spending. Foreign investors have sold a net $219 million of Philippine shares in August after buying $1.6 billion this year through July.



That's the Philippine peso, courtesy of Greg again. Same story, different currency.

Meanwhile, Thailandground zero for the Asian Crisis of 1997-98 — has shown that investors' memories may not be as short as the recent series of new lifetime highs in Western equity markets would perhaps suggest:

Source: Bloomberg

In Thailand's case, not only have the currency and equity markets been battered by fleeing investors, the country's bond market has taken what is known in the UK as a good old-fashioned shoeing. Here's Greg again:

Thai%20Bonds.psd Source: Greg Weldon

So we have what can safely be classified as a rout in emerging markets, but it's the quietest rout nobody ever heard of, because the US has been faring remarkably well. However, because the root cause of the rout is Fed policy shifts (or hints of shifts), the rout will eventually come home to roost.

Mark my words.

This past week, Ambrose Evans-Pritchard pointed out that, as it gathers pace, this is one meltdown that the Fed simply cannot just ignore even if it currently chooses to try — and that the scale and scope of what is happening in emerging markets matters a whole lot more now than it did the last time things came a little unglued:

(Ambrose Evans-Pritchard): The US Federal Reserve has told Asia, Latin America, Africa and Eastern Europe to drop dead.

This has the makings of a grave policy error: a repeat of the dramatic events in the autumn of 1998 at best; a full-blown debacle and a slide into a second leg of the Long Slump at worst.

Emerging markets are now big enough to drag down the global economy. As Indonesia, India, Ukraine, Brazil, Turkey, Venezuela, South Africa, Russia, Thailand and Kazakhstan try to shore up their currencies, the effect is ricocheting back into the advanced world in higher borrowing costs. Even China felt compelled to sell $20bn of US Treasuries in July.

"They are running down reserves by selling US and European bonds, leading to a self-reinforcing feedback loop," said Simon Derrick from BNY Mellon.

We are told that emerging markets are more resilient than in past crises because they have $9 trillion of reserves. But any use of that treasure to defend the exchange rate entails monetary tightening, and therefore inflicts a contractionary shock on countries already in trouble.

The numbers are quite frightening when you think of how far these countries have come in such a short time. In a world where 50% of the economy is accounted for by emerging markets, things could get mighty sticky, mighty fast. Says Ambrose:

[F]oreigners bear 90pc of the currency risk in Malaysia, 81pc in Thailand, 79pc in Korea and 74pc in India. So let them take the haircut. Should these countries take that course, they will inflict a deflationary trade shock on the West. The eurozone is in no fit state to handle that. Nor is Britain.

We are in entirely uncharted waters. Emerging markets were less than 15pc of global GDP in the early 1980s, when tightening by the Volcker Fed brought Latin America crashing down. That was an ugly episode for Western banks, but easily contained. China was then in autarky, shut off from the world. The Soviet Union and its satellites formed a closed system.

The picture was already very different by the mid-1990s, when ex-Communists had joined the party. By then emerging markets had grown to a third of global GDP, big enough to rock the boat, as Fed chair Alan Greenspan discovered after Russia's default in August 1998.

Amen to that, Ambrose, and well put.

But if the Fed's potential moves have already been bad for Indonesia, the Philippines, and Thailand (and I might as well mention Singapore, whose stock market has fallen 7.5% in the last ten days, and Malaysia, which gave up a quick 7% in a month), the biggest effects have been felt in the country I focused on last week: India.

The fall of the rupee is now reaching a crisis point, and although it has retraced some of its almost perpendicular move to an all-time low of 68.84 versus the dollar last week, it is by no means out of the woods. Not by a long shot.

Source: Bloomberg

How much trouble is the rupee in? Well, since last week, when I wrote to you about Indians' love affair with gold as a means to protect themselves from currency depreciation and their government's attempts to break up that particular romance, the Indian government has outdone itself.

Now, bear in mind as you read the following that the people mulling over these ideas are themselves Indians who know exactly what gold means to their fellow citizens, and then calibrate the harebrainedness of this scheme accordingly:

(Reuters): India is considering a radical plan to direct commercial banks to buy gold from ordinary citizens and divert it to precious metal refiners in an attempt to curb imports and take some heat off the plunging currency.

A pilot project will be launched soon, a source familiar with the Reserve Bank of India (RBI) plans told Reuters. India has the world's third-largest current account deficit, which is approaching nearly $90 billion, driven in a large part by appetite for gold imports in the world's biggest consumer of the metal.

With 31,000 tonnes of commercially available gold in the countryworth $1.4 trillion at current prices diverting even a fraction of that to refiners would sate domestic demand for the metal. India imported 860 tonnes of gold in 2012.

"We will start a pilot project among some banks where we will allow them to buy back gold from individual households," the source, an official familiar with the central bank's gold policymaking, said. "This will start soon, we have discussed (it) with banks."

The RBI will ask the banks to buy back jewelry, bars and coins for rupees. Lenders will have to offer better rates than pawn shops and jewelers to lure sellers.

Stupefying. Utterly, UTTERLY stupefying.

Indians buy gold because they don't trust the government or the rupee or the Reserve Bank of India that prints them, so if your solution to the problem of wholesale public exchange of fiat currency for gold is to offer to buy back that gold for — yes, I know, but I have to spell it outfiat currency, then you have reached a level of stupidity that even I have a hard time comprehending.

Fortunately, though, there is historical precedent:

(Reuters): Any talk of using the country's gold to help meet India's international obligations revives memories of a 1991 balance of payments crisiswhen India flew 67 tonnes of gold to Europe as collateral for a loan to avoid a sovereign debt default.

Yes, India's leaders have been down this road before, but never let it be said that previous demonstrations of ineptitude or bad policymaking might deter them from forging ahead with another brilliant rework of an idea that has already been proven unpopular with their populaceafter all, this time is DEFINITELY different:

(Reuters): Selling gold reserves may sit badly with Indians, many of whom saw the 1991 sale as a public humiliation. The secret operation was only exposed after a vehicle carrying the first consignment of bullion broke down on its way to the airport from the central bank.

The Rupeestone Cops.

But on they go:

(Reuters): Earlier on Thursday, India's Trade Minister Anand Sharma said the central bank should look into the possibility of monetizing gold holdings.

It was not immediately clear whether Sharma was referring to the 557.7 tonnes of gold the RBI holds in its own reserves, or gold in private hands. He did not give more details of how the proposal would work.

"I have not said there should be any mortgaging of the gold, or auction of the gold, that is incorrect. I have just said the RBI should look into ... how they can benefit the people, particularly with regard to the bonds or the monetization," Sharma said in response to a question in parliament.

Naturally, with new incoming RBI governor Raghuram Rajan ready to take the hotseat, speculation turned to what he might do once he takes up the poisoned chalice reins:

(WSJ): As the Indian currency keeps sinking against the dollar, some economists say the Reserve Bank of India's incoming governor might have no choice but to raise interest rates sharply, reminiscent of actions taken by U.S. Federal Reserve Chairman Paul Volcker in the U.S. in the 1980s.

Mr. Volcker bucked political pressure to keep rates low and instead hiked benchmark rates to record levels to curb high inflation. But while inflation came under control in the early 1980s, it also left ... the U.S. economy in a recession.

Some economists say that a similarly drastic step may be needed if Indian authorities are unable to arrest the rupee's slide soon.

"If they keep missing the boat like they have been, they will be left with no policy options but to hike [interest rates]," said Shweta Singh, a London-based economist at Lombard Street Research.

Ms. Singh proposed in a research note last week that it could fall upon Raghuram Rajan, who takes over as RBI governor on Sept. 5, to follow Mr. Volcker's steps.

Seems sensible enough.

But, as Bloomberg neatly summed up, the nature of India's problems is such that it may not be that simple for Rajan:

(Bloomberg): To restore strong and stable growth, India will have to curb public borrowing, reduce its external deficit, attract foreign investment and get inflation back down.

India's dysfunctional political landscape only makes matters worse:

(Bloomberg): Thanks to the gridlock in New Delhi, the RBI is being asked to do it all with the one and a half policies at its disposal: interest rates (a powerful economic tool) and foreign-exchange intervention (a puny one). That's impossible, and it would be a big mistake for the RBI to try.

Best of luck, Raghuram — you're gonna need it.

So we have equity markets AND currencies in Indonesia, the Philippines, Thailand, India, and to a lesser extent Malaysia and Singapore all in various states of freefall; but thankfully, the contagion is limited to Asia.

Brazil is part of Asia, right?

(UK Daily Telegraph): Dilma Rousseff, Brazil's president, held an emergency meeting on Thursday with her top economic officials to halt the real's slide after it hit a five-year low against the dollar. The central bank chief, Alexandre Tombini, cancelled his trip to the Fed's Jackson Hole conclave in order "to monitor market activity" amid reports Brazil is preparing direct intervention to stem capital flight.

The country has so far relied on futures contracts to defend the realdisguising the erosion of Brazil's $374bn reserves — but this has failed to deter speculators. "They are moving currency intervention off balance sheet, but the net position is deteriorating all the time," said Danske Bank's Lars Christensen.

Yes, Brazil, which fired the opening salvo in the developing global currency war, is now watching its currency, the real, and its equity market come under severe pressure.

Source: Bloomberg

Stephen Jen of SLJ Macro Partners is worried:

These are pre-quake tremors: something big is coming," Stephen Jen, the co-founder of hedge fund SLJ Macro Partners LLP, said in a phone interview from London on June 12. "There's tremendous deceleration in emerging markets. You may see crisis-like price actions without having a crisis.

See? I told you he was worried.

"This is a dangerous period," Jen said. "The Fed will start to normalize rates. It's a gradual process, but the pressure will only point in one direction, which is in favor of the dollar and against emerging markets."

Last week, Brazil's central bank took action with a $60bn currency intervention aimed at stemming the Real's side, promising to sell $500mn in currency swaps on Mondays through Thursdays and multiple $1bn repos on Fridays.

Saturday and Sunday will remain intervention-free.

However, the country cut its GDP forecast for 2013 and 2014 and has seen yields on its 10-year bonds jump to 12% (before falling back below 11%). Brazil's need to stamp out inflation whilst kick-starting a moribund economy puts it in straits similar to India's.

Again, good luck.

The root cause of all this instability is, as I said at the beginning of this piece, Benny and the (Ink)Jets and their frivolous generosity. As emerging markets unravel in the face of a taper that was always inevitable at some point, the corner that the free-money Fed has painted other central banks into becomes ever more apparent as it shrinks.

There really is no way out now, I'm afraidnot without some kind of organic growth allied with controlled inflation.

Emerging-market central bankers need both. They have neither.

Ambrose Evans-Pritchard nicely sums up the situation facing the Fed:

(UK Daily Telegraph): The Fed has a duty of care to emerging markets, since its own hands are hardly clean. Zero rates and quantitative easing were the cause of dollar liquidity flooding these countries. It was the biggest reason why net capitals flows into emerging markets doubled from $4 trillion to $8 trillion after 2008, much of it wasted in a late cycle blow-off.

Yes, China, Brazil, India and others handled the liquidity bath badly. They ramped up credit without generating much worthwhile growth. In China's case the economic return on loan growth has collapsed from a ratio of 0.85 to 0.17. The diminishing returns have shrunk to almost nothing.

The credit boom disguised the underlying rot as the BRICS club lost labour competitiveness. Every case is different but nowhere was myth so divorced from reality as in Brazil. The country is languishing at 130th place in the World Bank's rankings for ease of doing business, industrial output is still 3pc below pre-Lehman levels and it has lost its way with dependence on iron ore and commodity exports.

As Matt King from Citigroup says in a pithy note, tourists have discovered that "reality is less good than the brochure" in emerging markets and now they are pining for home. "Don't all come home at once. The exits are small," he warned.

One cannot blame the US for the failings of these countries, yet Ben Bernanke and his successor will still have to live with the consequences. Globalisation has entrapped the Fed. Like it or not, the Fed is the world's monetary superpower.

The exodus of money from emerging markets that we have seen so far is nothing compared with what could happen if this episode is mishandled. The rapid escalation towards a Western missile strike on Syria is bringing matters to a head fast, with talk of a spike in crude oil prices to $150 a barrel setting off its own chain reaction.

If the Fed really thinks that the rest of the world will have to "adjust to us" as it insists on draining global liquidity come what may, it may have a very rude surprise, yet again.

Amen again, Brother Ambrose. A rude surprise may well await the world.

As Ben Bernanke eyes his own exit, Janet Yellen and Larry Summers wait in the wings to see which of them gets to take the handoff of the ominously swaying monkey chain from the incumbent chairman's hand.

One false move and all the monkeys may end up in a heap on the floor..