Why the US Federal Reserve should care about finance
A fresh approach to monetary policy should look at markets for signs of overheating
Rana Foroohar
Emerging market stocks, last year’s darlings, are collapsing. Does this mean the bubbles of an artificially inflated market are finally bursting? It is a question worth asking a decade on from 2008. As every Financial Times reader knows, the world’s central bankers were responsible for ensuring that the Great Recession did not become another Great Depression by keeping interest rates low and holding an eye-popping $15tn on their balance sheets.
This led to stock markets reaching all-time peaks, even as it has failed to create any sort of real wage growth. Central banks can create asset bubbles, of course, but they cannot change the wage-suppressing effects of globalisation, technology-driven deflation, and an increasing concentration of corporate power that makes it impossible for workers in rich countries to have any real bargaining power.
I am not faulting the US Federal Reserve, the European Central Bank or any of the other institutions that have run the world’s largest-ever experiment in unconventional monetary policy — although I would argue that, by this point, it is not so unconventional.
Since Alan Greenspan’s era in charge of the Fed, the bias has been to leave rates low and worry about the inevitable asset bubbles later. It is an understandable attitude, particularly given the inability of politicians in the developed world to push through big infrastructure plans, or educational reform, or other things that would actually change things for ordinary people, over the past 10 years.
But it is clear that we have reached the boundaries of what easy money can constructively do.
When 10 per cent of the US population owns 84 per cent of the shares, asset price increases do not create inflation, but inequality.
While Fed chair Jay Powell’s first major speech at Jackson Hole last month made it clear he would not move away from business as usual any time soon, I was most intrigued by a single passage at the very end. It seemed to indicate the Fed knows the current strategy is not really working any more.
“Inflation may no longer be the first or best indicator of a tight labour market,” he said, noting that “in the run-up to the past two recessions, destabilising excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses.”
Translation? The Fed chief is admitting that financialisation exists and the markets are now the tail that wags the dog. Central bankers and most economists tend to work with a model that assumes economic downturns create market downturns. But Mr Powell is hinting that the reverse may be true.
This is a big deal. But it is not really a new insight. Far from being a blind follower of “markets know best” efficiency theory, Mr Greenspan himself was well aware that easy monetary policy and stock prices could create bubbles in the market that may have terribly damaging real-world effects (he wrote a paper on the topic in 1959).
Why, then, did Mr Greenspan, and every Fed chief since, allow bubbles to expand and burst rather than getting out in front of them?
The particulars depend on the regime. Despite his sideways references to “irrational exuberance”, Mr Greenspan was a finance-friendly regulator who did not want the music to stop. His successors, Ben Bernanke and Janet Yellen, believed that low interest rates were the only thing standing between the American population and the breadline. Either way, politicians have never made it easy for central bankers to take the punch bowl away.
Does anyone doubt that this mega-bubble will eventually burst? When it does, the results will inevitably ripple through the real economy (academic research shows that most recessions since the second world war followed stock market collapses).
It is possible that the current downturn in emerging market stocks could spread and be the trigger for the economic slowdown that most people believe is coming in the next couple of years. Given this, I would argue we should drop the “wait and see” approach to monetary policy. Ten years after the crisis, and four decades after interest rates began their steady decline, it is time for a fresh approach to monetary policy.
What might this entail? For starters, central bankers should make financial markets a more central part of their models. It is amazing that they are not already front and centre, given the rise of financialisation since the 1980s. Mr Powell admitted that “inflation sends a weaker signal” now than in the past, which makes it important to look elsewhere for signs of overheating.
What metrics might the Fed and other central banks look at? I suggest three. First, the pace of run-up in debt, always the biggest predictor of market trouble. It has been growing more rapidly than gross domestic product for a number of years. The growth of financial assets relative to GDP is also near record levels. Margin debt, ditto.
Or, just take a walk around Brooklyn, where I live. In Bedford-Stuyvesant, a neighbourhood where street shootings are still an issue, a townhouse recently sold for $6.3m. As was the case before 2008, sometimes the best economic indicators are the ones next door.
WHY THE U.S. FEDERAL RESERVE SHOULD CARE ABOUT FINANCE / THE FINANCIAL TIMES OP EDITORIAL
U.S. INTEREST RATES ARE SPIKING AGAIN: WHY? / DOLLAR COLLAPSE
US Interest Rates Are Spiking Again: Why
The bond market reacted as you’d expect to the prospect of higher wage inflation, with the yield on 10-year Treasuries hitting its highest level in five years.

This is good news for long-suffering savers and retirees who can finally generate a decent return on their investments. But it’s potentially disastrous for the broader financial system, which is now so over-leveraged that interest rates returning to historically-normal levels pose a mortal threat.
To understand how this works, consider the federal government’s rapidly-rising debt…
source: tradingeconomics.com
… and the related interest expense:

Notice a few things:
2) The recent 25% spike in interest expense in just three years exceeds the percentage increase in government debt because interest rates rose concurrently. So the US is now being hit with a double-whammy of debt that’s both rising and becoming more costly.
3) Now the real trouble begins. As the government’s short-term debt is refinanced at ever-higher interest rates, interest expense will rise even more steeply. Within three years at the current rate of borrowing, US total federal debt will be $25 trillion. An average interest rate of 4% — below the historical norm and easily within reach if current trends continue – will produce an annual interest expense of $1 trillion. Interest will be the government’s largest single budget item, raising the deficit and adding to future debt increases. The perpetual motion machine will have shifted into reverse.
For a sense of what this means for the US economy, just look at the countries that are a bit further down this path. Once the “rising interest expense begets higher deficits begets rising interest expense” idea takes hold, there’s no fix, only a choice of crises. Argentina just raised its official lending rate to 60% in an attempt to stabilize its collapsing currency. But how many businesses can refinance their debts at this rate? Not many. So a crash is virtually inevitable.
source: tradingeconomics.com
Turkey, meanwhile, is apparently trying to talk its way out of a similar mess, without success. See Turkey’s currency slides as inflation spikes to its highest level in 15 years.
The idea that the US is immune from this kind of basic math will be tested shortly. And the answer will almost certainly be that the laws of finance apply to everyone, including superpowers.
THE PRICE OF EVERYTHING: A SCRAMBLE TO REPLACE LIBOR IS UNDER WAY / THE ECONOMIST
The price of everything
A scramble to replace LIBOR is under way
Scandal and rickety economics have undermined the benchmark interest rate
SITTING in his office in the Wrigley Building overlooking the Chicago river in 2012, Richard Sandor, who has spent his career inventing financial products, was reading about the scandals surrounding the London Interbank Offered Rate (LIBOR), an array of interest rates set daily by a club of banks in Britain and used to price trillions of dollars’ worth of loans, derivatives and more. “This is stupid,” Mr Sandor recalls saying to a colleague. “Let’s make a bet; LIBOR will lose its pre-eminence.”
Two years later the Federal Reserve reached the same conclusion. It formed a group, the Alternative Rate Reference Committee, which has created a new benchmark dollar interest rate, the Secured Overnight Financing Rate (SOFR). Since April, SOFR has been used for a handful of bond offerings by large institutions including the World Bank, MetLife and Fannie Mae. Central banks in Britain, the euro zone, Japan and Switzerland are also constructing new benchmark rates.
LIBOR is heading for extinction. Its fate was sealed in July 2017 when Andrew Bailey, head of Britain’s Financial Conduct Authority, a regulator, said it would be phased out in 2021. It had been undermined by twin scandals. In the first, a product of the crisis, the rate-setting banks tweaked their quotes, possibly with supervisors’ implicit support, to limit the chances of market panic. In the second traders manipulated the rates subtly, to gild their profits.
The ruckus cost Bob Diamond, the chief executive of Barclays, his job and Tom Hayes, a trader at UBS and Citigroup who was jailed for 11 years, his liberty. Oversight of LIBOR was transferred from the British Bankers Association, a trade body, to British regulators and then to Intercontinental Exchange, an American stock- and derivatives-exchange group. In June Société Générale agreed to pay American authorities $750m to settle a charge of manipulation, adding to a list of seven other big banks. (The French bank also agreed to pay a large sum to settle charges related to a bribery scheme in Libya.)
From fiction to friction
LIBOR also rests on shaky economics. Its roots go back to an informal coalition of London banks in the 1960s. This was formalised into a panel of 20, which submitted daily estimates of their borrowing costs for up to five currencies and seven maturities of up to a year. Yet some quotes are little better than guesses. In July Randal Quarles, the vice-chairman of the Fed in charge of bank supervision, noted that just six or seven transactions a day were used to set one- and three-month dollar LIBOR and an average of one for the 12-month rate, for which on “many days there are no transactions at all”. A few banks have dropped out of the panel; some are staying until 2021 only at the FCA’s request.
On this flimsy foundation a staggering $260trn-worth of financial products, from interest-rate swaps to retail mortgages, are priced, estimates Oliver Wyman, a consulting firm. Dollar LIBOR accounts for by far the biggest chunk, not far short of $200trn; sterling and yen weigh in at $30trn apiece and Swiss francs at $5trn. The chief benchmarks for euros, EURIBOR and EONIA, face an even tighter timetable for reform and replacement than LIBOR. (EONIA does not comply with a recent European Union directive and must go by the end of 2019.)
Creating and then switching to truly market-based alternatives is an almighty task. The Fed’s approach was to tap into the “repo” (repurchase) market. Banks seeking short-term cash sell securities with little credit risk, such as Treasuries, to other banks with a promise to buy them back the next day at a slightly higher price. The difference is in reality the interest rate on an overnight loan. To ensure repayment, they provide collateral. There are $700bn-worth of these transactions daily, which are reported to the Fed through the Depository Trust & Clearing Corporation and the Bank of New York Mellon. After ingesting and processing vast quantities of data to produce a weighted average, the Fed publishes the result, SOFR, at 8am.
Take-up has been slow. So far only seven or eight bonds have been sold using SOFR as a reference price. Doubtless this is partly because of investors’ unfamiliarity with a new product, compounded by the Fed’s inability to explain itself to those who do not understand its jargon. But it may also reflect difficulties with using overnight, near-risk-free rates.
For a start, an overnight rate is exactly that: a term structure has to be constructed for longer maturities, for instance from expected or actual overnight rates. SOFR also reflects the rate on extraordinarily high-quality, essentially risk-free credits, which would default only if America’s government failed. Using it as a benchmark may therefore risk creating a mismatch for the average bank. In a crunch, SOFR may fall as investors run for safe assets, pushing down banks’ revenues from SOFR-linked loans. Yet banks’ own borrowing costs on wholesale markets will increase.
In addition, legal problems loom, and time is short. Contracts continue to be written on LIBOR, of which plenty extend beyond 2021. The Bank of England noted in June that the number of such LIBOR-linked sterling derivatives had risen since the previous year. Many contracts, the bank went on, lack “fallback” clauses setting out which rate applies once LIBOR goes. British regulators wrote to banks on September 19th instructing them to provide by December a summary of their plans for mitigating LIBOR-related risks.
Meanwhile Mr Sandor has developed his own benchmark, which is steadily attracting customers. By 2015 he had convinced a handful of small banks to join his new American Financial Exchange, which now has 99 members and where $1bn-worth of loans are traded daily. From those transactions, a benchmark overnight interest rate for unsecured loans, Ameribor, has been derived.
This month Ameribor was used for the first time in pricing a loan, by ServisFirst Bank of Birmingham, Alabama, to a car dealer in Tennessee. The bank’s chief executive, Tom Broughton, says that it considered SOFR, but because it does not use Treasury repos and its liabilities are not secured, it needs a rate that can accommodate credit risk. Mr Sandor hopes that in two to three years Ameribor will become a benchmark for many of America’s 5,000 regional and community banks and their customers. Whether or not that happens, the era of LIBOR is ending.
TURNING POINT? / SEEKING ALPHA
Turning Point?
- There are signs that September marked a turning point beyond which ex-U.S. assets, and EM particularly, should be due for a tactical bounce.
- Here's an in-depth breakdown of the arguments for and against the "convergence" trade complete with a table documenting the history of U.S.-EM divergences.
Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.
There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.
The bottom line is that while there are signs that the EM pain may be short-lived, the problems in Turkey and Argentina aren't going to be resolved any time soon and it seems just as likely as not that the dollar will continue to be underpinned by higher rates in the U.S. and expectations of a more aggressive Fed.
My contention is that Jerome Powell will live to regret the statements excerpted here at the outset.
Our view in favor of a rotation towards the RoW and EM is based on the premise that the global growth cycle is not over and that stresses in EM are much less severe than those leading into the 2015 crisis. Why is the current situation different? One can look at the scale of two important drivers of EM stress: USD and commodities.
In 2014-16, the USD rallied ~25%, which should be compared with a ~5% rally in the current episode. Being already near the top of the ~5-year range, there is a low probability the USD can go another 10% or 20% higher (e.g., Trump or the Fed would likely not allow it). Also if one looks at commodity prices, in 2014-16 they declined by ~45% vs. a more modest ~7% decline this year. So by these measures the current stress is five times smaller than what was experienced in the 2014-16 time period. However, we do acknowledge that interest rates are higher in the recent period. We agree that current EM fundamentals are worse than those of DM, but given the recent price action, EM could be the best-performing assets from now to the end of the year, and still be the worst-performing assets for the year.

A concrete take-away from the historical playbook is that divergence tends to result in EM rallying (8 of the 10 episodes). Half of these rallies are substantial in length (12 months or longer) and half are relatively short-lived (~4 months). The remaining 2 episodes of divergence resulted in both the S&P 500 and MSCI EM selling-off; in other words, there is no divergence episode that was resolved by S&P 500 immediately catching down to MSCI EM.
WHY ITALY´S GOVERNMENT BONDS ARE SO UNSTABLE / THE ECONOMIST
Buttonwood
Why Italy’s government bonds are so unstable
If you fret about the euro’s survival, Italian bonds might be the last asset you sell
A SHREWD observer of London’s after-work drinking culture once offered the following bit of mathematical heterodoxy to explain it: “There is no number between two and six.” If you go out with colleagues and stop at two drinks, you will be able to summon the will to go home at a reasonable hour. After a third drink, another will seem like a good idea—and another, and another. You will be on course for a hangover.
A modified version might apply to Italy’s bond market. As long as yields are two-point-something or lower, they are sustainable. At that level, the bonds are safe. Italy’s public finances are stable. As yields rise above 3%, they may become unmoored. The bonds start to look like speculative instruments. The stability of public finances is in question. Yields might plausibly spike to 6% or more.
It is thus a source of anxiety that Italy is on its metaphorical third pint, with yields on ten-year government bonds hovering around the 3% mark. In part this reflects lingering concerns that Italy’s coalition government will table a budget for 2019 that breaks the euro zone’s fiscal rules. More generally, investors are asking themselves what is the right price for Italian risk. The wiser among them admit that they simply do not know. For Italy’s bonds come with a set of implicit options attached that make them tricky to price.
To make sense of Italy’s bond markets, it helps first to make a distinction between safe assets and credit securities. An American Treasury bond is the archetypal safe asset. Yields are largely determined by the interest-rate policy of the Federal Reserve. Bondholders do not worry much about the federal government’s ability to service its debts, which are, after all, in the currency it issues. The typical credit security is a dollar bond issued by a company, such as GM or Apple, or by a country, such as Brazil or Mexico. Its yield will vary with that of a Treasury of the same maturity, with an interest-rate premium, or “spread”, to compensate bondholders for the risk that the borrower might not earn enough dollars to pay its debts.
Neither IPA nor lager
It is hard to draw a line between safe bonds and credit in the euro zone. In contrast with America, there is no unique issuer of the currency. The European Central Bank (ECB), a sort of joint venture, prints the euros. German bunds are treated as the benchmark safe asset, simply because Germany is the zone’s largest economy and has a reputation for thrift.
Which other countries might qualify is a subject of lively bar-room debate. The ECB’s quantitative-easing programme gave the appearance of safety to all euro-zone government bonds, even Italy’s. The ECB in effect covered Italy’s net bond issuance over the past three years, says Lorenzo Codogno, of the London School of Economics. But QE is coming to an end. Other buyers must be found. It is not a coincidence that anxieties about Italy’s public debts, sickly economy and fractious politics have resurfaced.
To make matters worse, Italy’s bonds are not a straightforward credit in the way that, say, Mexico’s dollar bonds are. They come with more implicit options. How should investors, for instance, treat the pledge made in 2012 by Mario Draghi, the ECB’s boss, to do “whatever it takes” to save the euro? When push comes to shove, the ECB might decide that an Italian default would be fatal to the single currency and start buying bonds again. Or it might not. This kind of vague, embedded option is difficult to value. Andrew Balls of PIMCO draws a parallel with the mortgage-backed bonds that were central to the global financial crisis. They once seemed safe. But they became so complex and opaque that they could not be priced.
Bonds are supposed to be simple. Italy’s are not. They are not an investment to buy for your widowed aunt. But some investors do not have the luxury of steering clear. Euro-zone insurers are all but compelled to own sovereign euro bonds and Italy’s market is the largest. The country thus looms large in the bond indices that are a benchmark for many asset managers. If you fret about the euro’s survival, Italian bonds might nonetheless be the last asset you sell. At least you are getting a higher yield in return for the risks. You are paid for your discomfort. That is not true of French bonds, which trade at only a small premium to Germany’s.
Think of the euro-zone bond market as an after-work drinks party. Germany dislikes buying drinks for others, and so has gone home. Italy is on its third trip to the bar. France, which is nursing its first drink, insists that it is leaving soon. But if a fight breaks out, it will get drawn in.
COPING WITH VENEZUELAN MIGRATION / GEOPOLITICAL FUTURES
Coping With Venezuelan Migration
By Allison Fedirka
|
Bienvenida
Les doy cordialmente la bienvenida a este Blog informativo con artículos, análisis y comentarios de publicaciones especializadas y especialmente seleccionadas, principalmente sobre temas económicos, financieros y políticos de actualidad, que esperamos y deseamos, sean de su máximo interés, utilidad y conveniencia.
Pensamos que solo comprendiendo cabalmente el presente, es que podemos proyectarnos acertadamente hacia el futuro.
Gonzalo Raffo de Lavalle
Friedrich Nietzsche
Quien conoce su ignorancia revela la mas profunda sabiduría. Quien ignora su ignorancia vive en la mas profunda ilusión.
Lao Tse
“There are decades when nothing happens and there are weeks when decades happen.”
Vladimir Ilyich Lenin
You only find out who is swimming naked when the tide goes out.
Warren Buffett
No soy alguien que sabe, sino alguien que busca.
FOZ
Only Gold is money. Everything else is debt.
J.P. Morgan
Las grandes almas tienen voluntades; las débiles tan solo deseos.
Proverbio Chino
Quien no lo ha dado todo no ha dado nada.
Helenio Herrera
History repeats itself, first as tragedy, second as farce.
Karl Marx
If you know the other and know yourself, you need not fear the result of a hundred battles.
Sun Tzu
Paulo Coelho

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