Transitions

February 14, 2014

By Doug Noland


"Risk on" strikes a comeback

Representative Frank Lucas: “…When we undo quantitative easing, what is the effect going to be on things like farm land prices or stock market prices or, for that matter, equities?”

Federal Reserve chair Janet Yellen: “I would agree that one of the channels by which monetary policy works is asset prices, and we have been trying to push down interest rates, particularly longer term interest rates. Those rates do matter to the valuation of all assets, both stocks, houses, and land prices. And so I think it is fair to say that our monetary policy has had an effect of boosting asset prices. We have tried to look carefully at whether or not broad classes of asset prices suggest Bubble-like activity. I’ve not seen that in stocks generally speaking. Land prices I would say suggest a greater degree of overvaluation.”

Lucas: Because, from the perspective of a number of us the concern about the old analogy - about the put your finger in the balloon and it pops out somewhere else - are concerns that we would potentially, unintentionally of course, create a Bubble similar to what we went through in housing a decade ago, either in farmland prices, or somewhere else. And the consequence of that is just most unnerving. Your predecessor once, in response to a question from me when I asked, ‘when will you know to undo the quantitative easing?’ His response was, ‘we'll know’. And my question then was, well if you didn’t know when the problem was coming, how are you going to know when the problem is fixed to undo? So, I appreciate the challenges you face. I certainly wouldn’t want your job. But then it took us two and a half years to do a farm bill too.”

Yellen: “Well, we will watch asset prices very closely and recognize they can be a sign of excesses that are developing.”

Representative Patrick Murphy: “The collapse of the housing bubble and resulting financial crisis devastated the global economy and cost Americans $17 trillion worth of wealth. Many of us assign responsibility for low interest rates and lax capital and leverage standards to the Federal Reserve and then chairman Greenspan. While I do not believe the Fed caused the crisis, its policies certainly helped fuel the Bubble. In June 2009, you said that higher short-term interest rates might have slowed the unsustainable increase in housing prices. With the benefit of hindsight, would measures to slow the housing bubble have been appropriate?”

Yellen: “I mean, certainly the collapse of housing in the Bubble were devastating and at the heart of the financial crisis. So, of course, yes, with the benefit of hindsight, policies to have addressed the factors that led to that Bubble would certainly have been desirable. I think a major failure there was in regulation and in supervision, and not just in monetary policy. So, I would say going forward, while I certainly recognize - and my colleagues do - that an environment of low interest rates can incent the development of Bubbles. And we can’t take monetary policy off table as a tool to use to address itit’s a blunt tool. And macro-prudential policies many countries do things like impose limits on loan-to-value ratios - not because of safety and soundness of individual institutions - but because they see a housing Bubble form and they want to protect the economy from it. We can consider tools like that, and certainly supervision and regulation should play a role and their more targeted policies.”

Murphy: “The reason I ask is would you be willing and open to pushing for policies to prevent another catastrophe, if it means the slowing or deflating an asset Bubble? And to sort of follow-up to that, are you seeing any Bubbles out there now or anything you’re concerned about?”

Yellen: Nothing is more important than avoiding another financial crisis like the one that we just lived through. So, it’s an immensely high priority for the Federal Reserve to do what we can to identify threats to financial stability. One approach that we’re putting in place in part through our Dodd-Frank rulemakings is simply to build a financial system that is much more resilient to shocks. The amount of capital in the largest banking organizations is doubled. We do have a safer and sounder system, and that’s important. But detecting threats to financial stability, we are looking for those threats. I’d say my general assessment at this point is that I can’t see threats to financial stability that have built to the point of flashing orange or redWe don’t see a broad-based buildup, for example, in leverage or very rapid Credit growth. Asset prices generally do not appear to be out of line with traditional metrics. But this is something we're looking at very, very carefully.”

Post-hearing headlines were for the most part consistent: “Yellen to Stay the Course.” Yellen to Investors: Expect Continuity at the Fed.” And from the Financial Times: “Yellen’s Promise of ‘Continuity’ Lifts Equities and Treasury Yields.

The markets apparently loved Yellen’s first Humphrey Hawkinstestimony before the House Committee on Financial Services. Listening intently, it didn’t strike me as all too impressive. Yet the new Fed chair won the day with congeniality, perseverance and, most importantly, a keen focus on maintaining (market-pleasing) policy continuity.”

The Fed’s activist reflationary policies have been wonderful for asset markets for going on five years. And, sure enough, Dr. Yellen sounded just like her predecessor. She answered the typical questions almost verbatim to Bernanke. They share the same academic mindset and analytical framework. I even winced when she repeated Bernanke’s explanation that global interest rates have remained low because of “an excess of savings over investment.” Yellen doesn’t see problematic excess or Bubbles, or troubling leverage or Credit growth. Apparently the Fed’s balance sheet doesn’t count. For me, it’s all become too reminiscent of the “deer in the headlightsbackdrop from late in the mortgage finance Bubble period.

This issue of “continuity” at the Federal Reserve is actually an intriguing one. On the one hand, the markets are comforted with a slow and predictable taper that will see QE continue through most if not all of 2014. Moreover, Yellen parroted Bernanke in leaving open the possibility of extending or even increasing QE. In the world of short-term focused speculative markets, it was all good and business as usual.

Meanwhile, at the Federal Reserve there are incipient indications of policy discontinuity. Yellen may hope to press on with the “Bernanke doctrine,” but other senior Fed officials have different ideas. The so-called policyhawks” are determined to end the Fed’s balance sheet (“moneyprinting) operations. Even some centrists are already questioning the economic thresholdregime. The hawk camp seems emboldened and ready to shift Fed policy back in the direction of traditional policymaking tools and doctrine. The non-doves can these days point to myriad indications of financial excess. The “hawks” can make a strong case that the risks of open-ended QE significantly outweigh the by now depleted benefits.

Federal Reserve Bank of Dallas President Richard Fisher and Federal Reserve Bank of Philadelphia President Charles Plosser have taken the lead in pushing back against the Bernanke doctrine. Interestingly, on Thursday Loretta Mester, a top advisor to Plosser at the Philadelphia Fed, was named President of the Federal Reserve Bank of Cleveland. And with Esther George presiding at the Federal Reserve Bank of Kansas City, there appears a strong nucleus of Federal Reserve Presidents that I expect to play a critical role in framing the policy debate going forward.

Seemingly lost in the discussion is that Dr. Bernanke emerged onto the scene in 2002 with a radical monetary policy framework. Two post-Bubble crisis periods provided fertile ground for the Bernanke doctrine. There was as well a further consolidation of power around the Fed chairman and his close circle. I also believe the global nature of the 2008 crisis and its aftermath further wrested policymaking power to a small cadre of global central bankers. Especially when I listen to recent speeches by Plosser and Fisher, I sense a desire within the Fed system to return to traditional monetary policy doctrine and a more traditional decentralized power structure.

February 14 – Bloomberg (Jason Scott): “The world needs to adjust to the Federal Reserve’s tapering, Australian Treasurer Joe Hockey said, backing a stimulus reduction by the U.S. that sparked market turmoil and emergency measures in some emerging markets. It’s not something that hasn’t been foreshadowed,’ Hockey said… The world can no longer rely on methadone every day. Sooner or later we need to wean ourselves off and that’s what tapering is about… Our own central banks have the responsibility to act in our own national interests… It’s a balancing act. The U.S. Fed can speak for itself, but I don’t see any systemic difficulties in developing nations.’”

Transition at the Fed is an unfolding story, as is how this all will impact global markets. From my perspective, the key issue for two decades now has been the steady intrusion of central banks and governments into contemporary money” and Credit along with the asset markets. What began with pegging short-term interest-rates evolved into virtual control over the pricing and allocation of system finance. Especially with the 2008 crisis, unprecedented monetary and fiscal stimulus led to historic market distortions on a global basis (“global government finance Bubble”). I’ll further argue that government intrusion into the marketplace went parabolicback in 2012 with Draghi’sdo whatever it takes,” immediately followed by open-ended QE from the Fed and then similarly massive QE from the Bank of Japan. Push-back is now coming on multiple fronts.

February 14 – Dow Jones (Christopher Lawton): “The German Constitutional Court’s recent decision to refer questions concerning the European Central Bank’s unlimited bond buying scheme to a top European court shows the program pushes the boundaries of its mandate, the president of Germany's central bank said Friday. Earlier this month, Germany's top court referred questions regarding the legality of the program to the European Court of Justice in Luxembourg, but not before criticizing it as a power grab. Speaking at an event in Bremen, Jens Weidmann, president of the Deutsche Bundesbank, said the court’s decision showed that it shares the concerns previously voiced by Germany's central bank, which has starkly opposed the program since its founding. ‘The court's declaration shows just how far the Eurosystem has stretched the boundaries of its mandate with its announcement to purchase unlimited government bonds of individual member states, if necessary,’ Mr. Weidmann said… The ECB and other central banks will face political challenges to pulling back on their loose policy, he said. The more that the euro zone becomes accustomed to ‘cheap money,’ the more it becomes a substitution for needed structural reforms.”

With the resignation of Prime Minister Enrico Letta, Italy will soon have its fourth government in two years. But with Italian 10-year yields at 3.69% and Italy's equities (FTSE MIB) already up 7.7% in 2014, markets greet the most recent bout of political instability with a smile. Italy is today a poster child for Weidmann’scheap moneybecoming a substitute for structural reform.

And while on the subjects of Transitions, government intrusion in finance, and “cheap moneydistortions, there were more rumblings this week out of the Chinese Credit system. In particular, there were more trusts in trouble, apparently more bailouts, and additional questions surrounding the stability of China’s “shadow banking system” (see “China Bubble Watch”). There was also further evidence that risk aversion is becoming more acute throughout the corporate debt market. Spreads for riskier corporate bonds were said to move to the widest levels in two years.

The “Bernanke doctrineheld that readily availablehelicopter moneyallowed the Fed to disregard asset Bubbles, while ensuring the U.S. avoided the type of policy mistakes that led to The Great Depression. The Draghi ECB’s do whatever it takes” was in response to what was viewed as an existential threat to the euro and European integration. Japan’s Abenomicsmonetary inflation was seen as necessary to escape the scourge of twenty years of deflation.

The way I see things, individual policymakers around the globe have believed that reflationary policy benefits greatly outweighed the risks for their respective systems. In the process, however, the oldfallacy of compositioncame into play. Concerteddo whatever it takes” “moneyprinting, market intervention and other reflationary measures in massive proportions inflated an unwieldy historic global Bubble. China has been at the heart of the global Credit Bubble.

February 14 – Bloomberg: Chinese banks’ bad loans increased for the ninth straight quarter to the highest level since the 2008 financial crisis, highlighting pressures on asset quality and profit growth as the world’s second-largest economy slowsChinese banks are struggling to keep soured loans in check and extend earnings growth as the slowing economy and government efforts to curb shadow financing make it harder for borrowers to repay debt. Standard & Poor’s said this week that loan quality will decline in 2014 as banks remain at risk from debt-laden local government financing vehicles and manufacturers with too much capacityChinese banks added 89 trillion ($14.6 TN) yuan of assets, mostly through loans, in the past five years, equivalent to the entire U.S. banking industry’s, CBRC data show. By comparison, U.S. commercial banks held $14.6 trillion of assets at the end of September…”

China today illustrates all the key perilous facets of Credit Bubble excess: self-reinforcing over-issuance and mispricing of Credit; government market intrusions, interventions and attendant risk misperceptions; gross misallocation of financial and real resources; overinvestment and malinvestment on an epic scale; corruption, malfeasance and obfuscation; systemic dependency on ever-increasing amounts of high-risk Credit creation; and policymaker confusion and lack of resolve to deal forcefully with Bubble excess.

China’sshadow bankingproblem today encapsulates the inherent risks of contemporarymoney” (“financial claims perceived as safe and liquid stores of nominal value”), most prominently money’s dangerous attribute of virtually insatiable demand. Incredible amounts of perceived safemoney” have flowed freely into risky Credits, while people have no idea what they’ve invested in. Credit risk has been further elevated by system-wide Credit excess, resource misallocation and corruption. The historic scope of the Bubble was made possible because of the faith Chinese have in their government and government-backed banking system – as well on an international basis by the perception that Chinese policymakers have everything under control (within a backdrop of massive QE and seemingly unlimited liquidity).

There was a crucial policy debate from the late-twenties that has become increasingly pertinent, especially for Beijing and Washington. In the “Roaring Twenties” there was recognition within policy circles that heightened speculation was fostering financial excess including Credit financing speculative trading and other ventures. At the same time, heightened economic vulnerability and downward pricing pressures had policymakers searching for ways to direct Credit into productive investment and away from speculation. Yet, at the end of the day, the intensity of 1927-1929 terminal phasespeculative excess ensured that liquidity and Credit flowed disproportionately to inflating market Bubbles. Thoughts, efforts and hopes that policy measures could redirect finance away from market Bubbles and to the real economy ended in complete and utter failure.

The Fed hopes to avoid market turbulence through a protracted QE taper coupled with highly accommodative forward rate guidance. Chinese officials hope to tighten finance oh so gingerly as to restrain Credit excess and asset inflation, while ensuring sufficient Credit to sustain strong economic growth and social stability. I contend that Washington and Beijing are both dealing with late-twenties styleterminal phaseasset and speculative Bubbles. The problem is that terminalexcess can inflict a tremendous amount of systemic damage in a relatively condensed amount of time. Both the Fed and Beijing seek respective peaceful and continuous Transitions. In reality, time is of the essence.


February 14, 2014 6:10 pm

Emerging-world fashions that change with the seasons

Over-enthusiasm for emerging markets is just one fashion I have seen in the past 16 years, says Mohamed El-Erian

Thai pro-government "Red Shirts" wave clappers as they gather at Rajamangala stadium in Bangkok on November 24, 2013. Thai pro-government "Red Shirts" gather to counter growing anti-government protests and to show support for the Yingluck Shinawatra administration©Getty


As I prepare to step down from Pimco at the end of March, emerging markets are once again in the news for all the wrong reasons. In Argentina the currency has collapsed, Thailand and Ukraine are riven with political conflict, and Turkey is shaky.

These developments are reminiscent of the turmoil in January 1998 when I first moved to the private financial sector after 15 years at the International Monetary Fund. Then, Thailand was reeling, South Korea was on the ropes, and both Russia and Argentina were on their way to sovereign defaults.


A recurrence of the blues in emerging markets is not what conventional wisdom expected just a short while ago. For years experts had argued that these once-ailing economies had grown strong. Bank balance sheets had been strengthened. International reserves were much larger and government debt lower. Institutions were no longer financing themselves by issuing lots of short term debt that had to be repeatedly refinanced

Governments had enacted sensible reforms. Even in the harsh winds of the 2008 crisis, the emerging world did not catch a dreadful cold.

Excessive enthusiasm for emerging markets is far from the only intellectual fashion that I have seen come and go during the past 16 years. Another was the view that western central banks possessed all the tools necessary to secure a great economic and financial moderation; one that guarantees sustained growth, jobs and price stability. But it is in characterising the role of banks in a modern market economy that commentators have been at their most faddish.

At one time a largely unfettered banking system was seen as providing the most efficient way to channel funds to productive investments that create jobs and prosperity. Since banks were thought to embody strong self-correcting forces, they could be regulated with a light touch

These days, however, the banking industry is regarded more as a leech. Banks are seen as suffering from serious institutional and human imperfections.

Their main function is the enrichment of insiders. Weak competition helped. Access to emergency bank funding and insurance paid for by taxpayers gave financiers a cushion when the music stopped. This, anyway, is the currently fashionable view

It, too, is an old one. It prevailed in the 1980s when western banks had to be bailed out after an irresponsible lending spree in Latin America. The 2008 crisis has given it new life.

In some ways today’s financial sector is little different from the one I first got to know decades ago. Markets still get overexcited when things are going well, only to go into a torpor when the skies darken. If anything, an even bigger amount of money turns on significant mood swings, threatening at times to tear the pendulum off its pivot.

Human behaviour plays a role here. Market participants, whether in banks or asset management, have their comfort zones and gut reactions. They are influenced by the quarterly earnings ritual and ever-shorter performance measurement periods. And they move in herds.

“A sound banker is not one who foresees danger and avoids it,” wrote John Maynard Keynes, “but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” For too many banks, it still makes more sense to risk failing conventionally than try to succeed unconventionally.

Then there is the influence of internal market dynamics. Market participants react to one another’s trades in ways that cause movements in asset prices that do not seem to reflect their underlying worth.


Innovation and financial globalisation have played a part. It was once difficult for investors to make bets on far-flung corners of the world economy, such as Kazakh banks and Nigerian breweries. Now they can do so through exchange traded funds listed on western stock exchanges. In good times, this helps capital reach more places faster. But it can also make markets more volatile, and make it easier for instability to spread.

Emerging markets are particularly vulnerable to this phenomenon. They are far more reliant on flighty foreign money unlike western markets, which are deep with capital from domestic savers. This accentuates both the ups and downs.

Financial upheavals reverberate in the real economy. In moments of excessive euphoria, credit flows too freely, bad loans are made and currency appreciation makes domestic producers less competitive. When the tide of money suddenly reverses, the consequences can include a credit crunch, recession and, in the worst cases, widespread insolvency.

Yet not everything has gone full circle. Regulators and shareholders no longer allow banks to make such risky bets, even though they hold more capital

Instead, more credit is extended by institutions that have less systemic importance, and can more easily be allowed to fail. Central banks have found quicker ways to deal with malfunctioning markets. And many more trades now take place under the spotlight of public exchanges.

On the surface, today’s financial system appears much more sophisticated than the one I joined 16 years ago. But because basic human behaviours remain the same, some of its underlying characteristics have not changed much. Today’s banks are still capable of both doing good and also causing damage. Prompted by regulators and public opinion, they have learnt from mistakes. But if they are to strike that still-elusive balance between efficiency, innovation and soundness, they have much left to learn.


The writer is the outgoing chief executive and co-chief investment officer of Pimco


Copyright The Financial Times Limited 2014.