The New Mediocre Neutral
by Doug Noland
October 3, 2014
For a couple hours on Thursday things were beginning to look dicey.
Bloomberg’s Tom Keene: “The ‘new mediocre,’ the new mediocrity that is out there. Color that for us. How is that different from Dr. El-Erian’s or Mr. Gross’s ‘new neutral’? What’s the distinction of your ‘new mediocre’?”
IMF managing director Christine Lagarde: “The ‘new mediocre’ has three components… One is it still has the legacies of the crisis: high indebtedness both sovereign and corporate and household sometimes. It has high unemployment in many corners of the world. Those are the legacies. Then we are facing serious clouds on the horizon, and we have a lot of uncertainty. So if you combine the legacies, the clouds and the uncertainty, we have this horizon of the ‘new mediocre’ where we are revising potential growth.”
Keene: “Well, the urgency that I heard in your speech today is almost on a calculus basis, a first or second derivative. There's an acceleration – an immediacy. We saw it in the stock market yesterday. Where I see it mostly is in declining commodity prices. When you speak to Olivier Blanchard and your economists, how concerned are they about what the markets are telling them about the ‘new mediocre’?”
Lagarde: “We are watching the markets with a concern and with a lot of hesitation, because there is clearly a discrepancy between the buoyancy of the markets in many ways - I think forex is a little bit different - but the buoyancy of the markets, asset values at their highest ever. Volatility is very compressed and low. And then at the other end, we see a real economy where recovery is not really strong. We see areas of very fragile recovery. So there is that discrepancy between the two which is quite worrying.”
The past two years have seen unprecedented monetary measures from the world’s major central banks that went way beyond even the 2008/09 crisis response to collapsing financial markets.
Draghi’s “do whatever it takes” coupled with Fed and BOJ open-ended “money” printing has placed an exclamation mark on an ongoing historic experiment in global monetary management. Now, with securities markets booming in the face of stalling growth, heightened financial instability and fragility, and strengthening disinflationary forces, some global policymakers are showing understandable concern. It’s interesting that Lagarde would note the “quite worrying” divergence between “buoyant” asset prices and weak economic performance. After all, she has been a leading proponent of (inflationist) QE measures – and all this “money” inflating global markets is conspicuously at the root of a now precarious Bubble dynamic.
The [Rick] Santelli Exchange segment “Politics vs. Central Banks,” CNBC, September 30, 2014:
“…Everyone on the floor is passing along a [Financial Times] article – interesting title ‘Merkel has a Duty to Stop Draghi’s Illegal Fiscal Meddling,’ by [prominent German economist] Hans-Werner Sinn. Now, think about what that says, and let’s think back, whether it’s our central bank, or the European Central Bank, the Japanese. The issue is central bankers have moved from being nudgers on monetary policy to basically [operators of] fiscal policy. In the U.S. it’s every bit the same. And there’s lots of talk and even comments by Ben Bernanke, Janet Yellen and many commentators – that the central bankers need to dabble in that direction, for an obvious reason: because of the politics, whether it’s the politics of Europe, the unsure nature of how Germany wants to stand up and stand its balance sheet along with the ECB’s, or in this country because there’s a logjam. Things can’t get done at least to the liking of the masses, to the citizens - to the voters. But what that really has done is it’s taken the voters out of the game. If central bankers didn’t have such a large foray into politics, well, politicians would have had to sink or swim on the merit - or lack therein - of their policies that weren’t creating the growth. But central bankers early recognized that they needed to buy time to create stability and the growth would surely come. But the problem is, in the parlance of trading, is that the spread between these two [growth and stability] continues to get wider and wider and wider.”
Rick Santelli has distinguished himself as the preeminent “market” commentator throughout this remarkable period in financial, economic and political history. The guy’s a hero, consistently providing unequaled analysis (fighting the good fight!) while too frequently being on the receiving end of hostility from waves of pundits that think they understand much more than they actually do. I thought his above comments were especially pertinent. I’ll try to build on his analysis.
Fundamental to my analysis – and key to understanding today’s backdrop – is appreciating that we continue down a course unique in history. Never before has global finance operated without restraints on either the quantity or quality of Credit – no gold/precious metals regimes, no Bretton Woods, nor even a functioning dollar reserve system to place restraints on Credit expansion. Moreover, Credit expansion has come to be dominated by non-bank finance, removing important traditional constraints to financial excess (i.e. bank capital and reserve requirements). Over time, the inherent instability of unfettered global finance has evoked progressively more “activist” central bank control over “money,” Credit, the financial markets and economies. And this market intervention and manipulation has fostered the greatest ever speculation in global securities markets – which has motivated only greater central control.
Back in the late-nineties, I was convinced there was a momentous evolution in finance that was going unrecognized both in the marketplace and at the Federal Reserve. I believed the Fed would move to responsibly check the explosion of non-bank “Wall Street finance” once they recognized how it was fomenting destabilizing impacts on asset markets (price inflation and precarious Bubbles) and distorting resource allocation to the detriment of the real economy. How dead wrong I was. They instead embraced asset-based lending and became a proponent of leveraged securities speculation. Indeed, manipulating the returns from financial speculation became history’s most powerful monetary transmission mechanism. Borrowing from a Chinese proverb, central bankers jumped on the tiger’s back and can’t get off.
Some might contend I’m delusional, but these days I’m convinced I grasp the unrecognized (fatal) flaw in contemporary finance and monetary management. This most protracted Bubble has come to see a growing majority of global Credit that is backed by inflating asset values.
Worse yet, global central bankers have resorted to targeting higher securities prices as the cornerstone of their “activist” (fight the scourge of deflation!) policy measures. Yet a Credit apparatus backed by inflating securities (quantities and values) is precariously unstable, with the world’s monetary managers now trapped in the greatest Bubble in history. After years of interplay between policy, Credit and the securities markets, the global financial system is at perilous risk to a meaningful decline in securities and asset prices. Central bank efforts to inflate their way out of debt problems and fragilities ensure that inflating securities markets diverge only further from troubled real economies. No solution will be found with inflationism – only deeper hardship.
It’s lunacy that central banks would ever target higher equities and risk asset prices as a primary monetary transfer mechanism. It’s reckless that a central banker would promise the markets to “do whatever it takes” to resolve crisis and structural fragilities. This only guarantees distorted market pricing and trading dynamics, certainly including excessive risk-taking and speculative leveraging.
Yet central bankers believe that they have no choice but to dominate markets – to dominate seemingly everything. Central bank QE made certain that an already colossal global pool of speculative finance expanded by additional Trillions.
To be sure, a global Credit “system” essentially backed by inflating securities prices and underpinned by policy assurances ensures intractable vulnerability. So central bankers pump and financial speculation ramps. Some get fantastically wealthy. Many aspire to get their share. Societies fray. Global animosities fester.
I believe the small cadre of dominant global central bankers appreciates today’s systemic fragilities. This explains why they did what they did starting back in 2012. It was a case of flooding global markets with liquidity in a desperate attempt to spur global reflation. Their actions incited “terminal phase” speculative excess throughout global securities markets, in the process throwing gas on investment spending booms in China and throughout Asia (not to mention U.S. technology, agriculture and energy exploration). Importantly, securities and asset Bubbles only exacerbated already powerful wealth redistribution dynamics at a heavy cost to social and political stability around the globe. Treasuries, bunds, commodities, EM and the currencies have begun to adjust to floundering global Bubble dynamics.
Circling back to Mr. Santelli, yes, “the voters have been taken out of the game.” Democracy has been benched. “There’s a logjam. Things can’t get done at least to the liking of the masses…” “If central bankers didn’t have such a large foray into politics, well, politicians would have had to sink or swim on the merit - or lack therein - of their policies…” The post-crisis backdrop and reflationary policymaking leave the “masses” disillusioned and bitter. Views on the markets, economy, policy and the future are incongruous and polarized. Trust in institutions has suffered mightily. Divisiveness rules, albeit between “the West” and the Russia/China block, throughout Europe, in the Middle East, between much of the world and the U.S., here at home between the so-called liberals and conservatives, within the ranks of the Democrats and Republican parties, on the streets of Hong Kong and at the micro community and company level. When it comes to the crucial responsibility of monetary management, morality and ethics have been taken out of the game – at enormous unappreciated cost. On an individual, family, company, local, state, national and international basis, there is deepening angst that global finance, global economic systems and policymaking are dysfunctional, unfair and unjust.
Outside the great bull market, so much has become uncertain and disquieting. And central bankers are at this point locked in a singular, overwhelming policy response – unwavering monetary stimulus in hopes of somehow inflating out of financial and economic fragility.
Somehow they continue to believe they are the solution instead of the root of the problem.
There is this dangerous view that they have become the only game in town. And it’s their game where they have virtually complete discretion to do whatever they think is required. As they’ve done repeatedly throughout history, present-day inflationists have resorted to creative rationalization and justification (i.e. “trickle down” wealth benefits from inflated securities markets).
I’ve in the past highlighted Adam Fergusson’s classic, “When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany.” In lucid and compelling detail, Fergusson chronicles how monetary inflation insidiously destroyed German society. Incredibly, the German central bank went about their money printing fiasco oblivious to the damage they were instigating. They believed they were being forced to print in response to outside forces and dynamics beyond their control. And the more they printed and added zeros the more these forces required ever greater quantities of currency. Once the monetary inflation really got going the central bank became completely hostage to the runaway printing press and attendant inflationary dynamics.
I know. I’m a complete lunatic for mentioning “inflation,” let alone Weimar hyperinflation. Much of the world has become too comfortable rebuking the “dogmatic” Bundesbank, German politicians and the German people for their “inflation paranoia.” But let there be no doubt, the world is in the midst of a hyperinflation in global finance. The outward inflationary consequences of this global inflation of electronic, market-based Credit are of an altogether different nature than those from disseminating newly printed 100 billion Mark paper notes directly into the Weimar economy. Yet the pernicious forces of inequitable wealth distribution, economic maladjustment and social and geopolitical upheaval – the consequence of great monetary inflations - are sadly reminiscent of episodes where money died throughout history.
People will look back at this period and have a really difficult time comprehending how so many intelligent people were convinced that central banks creating Trillions of new “money” out of thin air to buy securities was somehow accepted as “enlightened” policy. The Germans know better and to claim it’s some paranoid societal affliction is ridiculous. For good reason, the notion of “do whatever it takes” central bankers willing to make up the rules as they go along is anathema in Germany.
Mario Draghi this week introduced the ECB’s plan for buying asset-backed securities (ABS) and covered loans (similar to MBS). The Germans are adamantly opposed to a policy that they believe clearly circumvents rules governing ECB policy and would further redistribute German wealth. FT headline: “Mario Draghi Pushes for ECB to Accept Greek and Cypriot ‘Junk’ Loan Bundles.”
Leading German economist and president of the Ifo Institute for Economic Research, Hans-Werner Sinn’s FT op-ed (referenced by Santelli), “Merkel has a Duty to Stop Draghi’s Illegal Fiscal Meddling,” concluded with a noteworthy point: “…Germany’s constitutional court has expressly prohibited the German government from sitting back while the ECB oversteps its mandate. If politicians do nothing, any Germany citizen can petition the court and force them to act.”
Global market Bubbles these days have a lot riding on the ECB. Bullish propaganda has focused on Draghi’s plan for expanding the ECB’s balance sheet by a Trillion euros, in the process grabbing the QE baton from chair Yellen. Especially now that an incipient “risk-off” de-risking/de-leveraging dynamic has emerged in global markets, the issue of reliable ongoing central bank market liquidity injections has become market critical. Market participants have of late become somewhat at unease that Draghi might not actually have a Trillion to toss into in the liquidity pot – that perhaps he’s just talking the talk. This concern manifested into what was for a couple hours on Thursday one of those stomach-churning sessions for global markets.
Thursday saw European equities get just blasted. The German DAX was hit for 2.0% and the French CAC 40 sank 2.80%. Italian stocks were slammed for 3.9% and Spanish stocks 3.1%.
Losses were not limited to Europe. Argentina’s Merval index rallied off lows yet still ended the session down 7.5%. Brazil’s real currency traded to a five-year low, ending the week down another 1.6%. U.S. equities also succumbed to selling pressure. Curiously, as selling of European equities accelerated, both the yen and Treasuries caught strong bids. Stocks with leveraged exposure to securities markets were under intense selling pressure. The beloved tech stocks started to buckle. Miraculously, U.S. equities reversed and a potentially destabilizing de-risking/de-leveraging episode was left for another day. The S&Ps rallied 46 points from Thursday’s lows to Friday’s highs.
Friday’s market reaction to stronger-than-expected September non-farm payrolls data was similarly intriguing. Immediately upon the release, S&P500 futures advanced slightly. Bond prices traded down just a couple ticks. Meanwhile, in the currency markets all bloody hell broke loose. King dollar surged over 1%, while the euro, yen, British pound, Australian dollar, New Zealand dollar and Canadian dollar were crushed like bugs. Crude, the precious metals and commodities in general were taken out to the woodshed. The heavily bruised EM currencies took some more pounding.
All in all, it was one more in a string of captivating weeks. Global markets have turned increasingly unstable. Unhinged global currency markets, the foundation of international finance, appear a flimsy jumble. I saw added confirmation for the thesis of heightened risk of a problematic bout of contagious global de-risking/de-leveraging. A group of enterprising hedge funds lost a court ruling, with collapsing Fannie and Freddie equities and preferreds on Wednesday hitting funds for losses to the tune of several billion. I’ll assume leveraged players heading for the exits played a major role in Thursday’s European equity rout. It looks like “hot money” is determined to come out of EM. Benefit of the doubt to “risk off.”
Throughout the markets, liquidity issues are becoming a growing concern. Increasingly, operating with leveraged bets in global currency and securities markets is akin to cavorting through a minefield.
Unsettled markets have arrived on U.S. shores. This week saw already weakening speculator hands lose some brawn. This ensures ongoing volatility throughout global markets – boosting the probability of a market accident. Of course, our adroit monetary authorities would never allow that. A market pundit suggested that the Fed would be ready to respond in the event Ebola became a major threat. Now that’s comforting.