Renzi’s Great Gamble

John Mauldin

There is an extremely important election coming up, and I am not talking about the US presidential election. The upcoming referendum in either October or November in Italy may have as much or even more macroeconomic impact on the world as the US election, but hardly anyone outside of Italy is paying much attention to it – yet.

I have been saying for some time in interviews around the country that I think the referendum in Italy has even more potential impact than the Brexit vote did in the United Kingdom. And just like the Brexit vote, it is rife with emotion and political turmoil, making the outcome too close to call.

If you are a voter in Italy, your frustration (or maybe even anger) is entirely understandable.
The current prime minister, Matteo Renzi, has basically bet his career on this referendum, which would allow him to enact what most of us would see as much-needed reforms – in fact they’re the very Italian reforms that I have written about in my letters over the last five years and that I talked about in my previous two books. Italy has about as sclerotic a governmental process as any country in Europe, and that is saying something. There is no end of corruption and crony politics, with each faction wanting to keep the status quo and not have to give up any of its perks but wanting everybody else to give up all of theirs. Not unlike a country close to where I reside (I say with a smile and a sigh).

Seriously, friends, this needs to go on your economic radar screen. If the “no” vote wins, Renzi has promised to resign, which will throw Italy into a political crisis. Then there will be a real potential to elect parties that would call for a plebiscite on whether to stay in the European Union – Italexit – and is not at all clear today what the Italians would decide to do. Know this: the European Monetary Union really does not work very well, if at all, without Italy, and a “no” vote would be the death knell of the euro, at least as we know it today.

Nick Andrews, who writes for my friends at GaveKal, has done an excellent summary of the situation in Italy, and his latest posting is this week’s Outside the Box. This is not a long essay, but it is worth every bit of your attention.

I have just about recovered my operational abilities here at Mauldin headquarters (which is actually my office at home). We are taking steps to make sure there is never a repeat of this computer debacle. I can point fingers here and there; but as they say, the buck stops here.

I hope the weather where you are is as pleasant as it is here in Dallas. Have a great week. I will be writing this weekend about why I am so disturbed about the negative interest rates set by current monetary policy that is in control of the economies of the world. It should be interesting.

Your wishing he had been in Tuscany for a few weeks this summer analyst,

John Mauldin, Editor
Outside the Box

Renzi’s Great Gamble

By Nick Andrews and Stefano Capacci

Prime ministers come and go in Italy – four since the financial crisis – but precious little seems to change. The latest incumbent, Matteo Renzi, has pursued structural reform more energetically than his predecessors. But for all the progress he has made, he might as well have been wading through molasses. Now, in a bid to secure a popular mandate for his restructuring program, Renzi has bet his premiership on a referendum over badly-needed constitutional reforms. It is a high stakes gamble. If Renzi wins the vote, which is due in either October or November, his proposed measures will streamline Italy’s legislative process, breaking the parliamentary gridlock which has crippled successive governments, and opening the way to far-reaching economic reforms. If he loses, Renzi has promised to step down – a pledge that has turned the referendum into a popular vote of confidence in the unelected prime minister, his Europhile policies, and by extension Italy’s membership of the eurozone itself. As a result, a “No” vote in October will not just precipitate the fall of Renzi’s government; it could throw Italy’s long term membership of the eurozone into doubt, plunging the single currency area once again into crisis.

Policy no man’s land

Italy’s fundamental problem is that it is stuck in a policy no man’s land. Its old economic model, in place for much of the last three decades of the 20th century, relied on a combination of currency devaluation to maintain international competitiveness together with fiscal spending to support the poorer regions of the country’s south.

Signing up to the euro put an end to all that, preventing devaluations and prohibiting budget deficits at 10% of gross domestic product. However, the design of Italy’s bicameral parliamentary system, in which the upper and lower house – the Senate and the Chamber of Deputies – wield equal legislative power, made it almost impossible for any government to push through the structural reforms necessary for Italy to compete and prosper within the eurozone. The result has not just been depressed growth and relative impoverishment, but an outright decline in living standards, as Italy’s real GDP per capita has slumped to a 20-year low.

Such a below-par economic performance has led to a build-up of bad assets on the balance sheets of Italy’s banks, where 18% of all loans are now classed as non-performing. In turn, this bad loan overhang has eroded the ability of the banking sector to extend new credit to the thousands of small businesses which are the engine of Italy’s economy and which normally power employment growth. The result is stagnation.

To stand any chance of escaping this low growth trap, Italy needs to enact wholesale structural reforms to enhance its competitiveness relative to its eurozone neighbors. Notably, it needs to make the labor market more flexible to encourage job creation, it needs to lower the barriers to entry that protect much of the country’s service sector, it needs to overhaul a judicial system so sclerotic that bankruptcy proceedings can last 10 years or more, and it needs to restructure its fragmented and dysfunctional banking system.

The prescription might be clear, but Italy’s political system makes enacting reform all but impossible. Renzi has already tried to overhaul Italy’s labor market by attempting to dismantle the generous protections that make it difficult and expensive for companies to dismiss staff, and which therefore encourage businesses to hire only temporary workers, heightening economic insecurity among the young.

But Renzi’s attempt ran into bruising opposition from Italy’s powerful and well-subscribed trade unions. The results were a watered-down reform package that entitles existing permanent staff to a near-guarantee of lifetime employment, and a severe dent in Renzi’s popularity from which he is yet to recover. It’s a familiar story in Italy. Entrenched interests, whether represented by local and regional political leaders, unions, protected professions, or established private sector companies, exert enormous influence over the political process. All profit from the status quo, which promises they will continue to benefit from special protections and payouts. And because of the equal balance of power in Italy’s parliament, which means the Senate can block government legislation indefinitely, the consequence is political – and economic – stagnation.

Bloated and wasteful

Renzi’s referendum aims to change that. The prime minister is seeking popular approval for constitutional reforms that promise to cut the size of the upper house from 315 to 100 senators. Under his proposals, senators will no longer be directly elected, but will instead be chosen by regional councils, nominated by the mayors of big cities, or – in the case of five – be appointed by the Italian president. The reform will not only cut the costs of the notoriously bloated and wasteful upper house, where senators have traditionally enjoyed lavish expenses and generous pensions. Most importantly, it will downgrade the political power of the Senate so that it will no longer be able to obstruct government legislation entirely, but only to propose amendments that will be adopted at the discretion of the lower house (although the Senate will retain a say on constitutional ma tters, including the ratification of European Union Treaties). The objective is to increase the executive power of the government, and to tackle entrenched interests with additional measures that allow for new laws to facilitate popular referendums and to promote citizen participation in the political process.   

Unlikely alliance

However, powerful forces are arrayed against Renzi, and a “Yes” vote is far from assured. The proposed reforms have attracted opposition not only from establishment voices who benefit from the current arrangements. They have also drawn fire from constitutional lawyers and anti-establishment parties, including the populist 5-Star Movement, which argues the 50% simple majority needed to win the referendum is too low for constitutional changes that promise a concentration of political power unprecedented since the formation of the Italian republic in 1946.

Perhaps more importantly, Renzi’s pledge to resign in the event of a “No” victory has raised the possibility of a protest vote against the prime minister himself – the third unelected head of government in succession – from a broad cohort of the electorate which is thoroughly disillusioned with Italian politics. Increasingly disgruntled, these voters are sick of the corruption and self interest of politicians, and fed up with painfully austere policies that they believe to be dictated from Brussels and Berlin, and which they hold responsible for Italy’s poor economic performance.

The chances of a “Yes” vote in the referendum have not been improved by the slump in Renzi’s personal popularity following last year’s attempt to reform the labor market, and a series of small bank restructurings that saw retail savers “bailed-in” – forced to take losses – under new European Union banking regulations. From 40% after Renzi entered office two years ago with optimistic promises of reform, the approval rating of the prime minister’s PD party has fallen to little better than 30% today, much the same as that of the opposition 5-Star Movement. As a result, with two months to go the referendum is too close to call. Opinion polls indicate the “Yes” and “No” camps are running roughly equal, with a large proportion of voters still undecided.

If Renzi loses the referendum, not only will Italy remain in policy limbo, but it is highly likely his subsequent resignation will trigger a parliamentary election. Under new election laws passed last year, if a party fails to win 40% in the first round of voting, the top two parties go through to a second round. The latest opinion polls put Renzi’s governing PD party on 31% and the 5-Star Movement on 29%, with the next two largest parties – Silvio Berlusconi’s Forza Italia and the anti-establishment Northern League – level pegging on around 13%.

In recent years, Renzi’s PD government has represented the best hope for structural reform and economic modernization. But even if the PD party were to win a post-referendum election, there is a risk that, following Renzi’s resignation, the left wing of the party would wrest back control from the reformist center-right faction, damping hopes for further restructuring. Such a swing to the left would hardly be unique to Italy. In the UK, the militant left has captured the leadership of the main opposition Labour Party. In Spain, Podemos has split the left wing vote, and in France the ruling Socialists have come under pressure in the polls from the radical and Euroskeptic Left Party led by Jean-Luc Mélenchon.

At the moment, an election victory for the 5-Star Movement, which identifies as neither left nor right, appears at least as probable as a second round win for the PD. The Movement has already scored significant victories in mayoral elections in Rome and Turin, and enjoys increasing support across the country. Its broad stance is anti-establishment and in favor of direct participatory democracy rather than representative democracy, which it regards – with some justification in Italy – as an invitation to corruption. Beyond that, however, its platform is so vague that it is hard to pinpoint any concrete policies, except its call for a referendum on Italy’s membership of Europe’s single currency.

Leadership vacuum

Perhaps the biggest problem for 5-Star, however, is that it has no clear leader. Its founder and leading voice, Beppe Grillo, was found guilty of involuntary manslaughter in 1980 following a fatal road traffic accident, and so cannot run for public office under Movement rules barring candidates with criminal records. Without Grillo the parliamentary party would be leaderless, meaning 5-Star has no obvious prime ministerial candidate even should it secure a majority in the election.

All this means that the possibility of a “No” vote in Italy’s constitutional referendum come October or November is the biggest clear and present danger to the euro’s survival. Both 5-Star and the Northern League are promising a plebiscite on euro membership should they come to power in a post-referendum election. That does not mean a vote on Italy’s eurozone membership would lead directly to its exit – many likely “No” voters in this year’s constitutional referendum favor continued euro membership. However, a “No” vote come October would effectively be a vote against the structural reforms needed to ensure Italy’s economic growth and prosperity within the eurozone.

In other words, in the event of a “No” vote in October, the only economic choice for Italy would be between continued stagnation, or a return to the old economic model of successive devaluations. The latter course would naturally mean exiting the eurozone anyway. But even if Italy were to take that path, it would hardly be a less painful way to restore the economy to health. Whether inside or outside the single currency, Italy still needs structural reform to ensure future growth. The only potential benefit to leaving the eurozone would be that deep devaluation of a reconstituted lira could help to ease some of the transitional pain (although it is probable the palliative effect would be more than offset by the additional economic and financial damage wreaked by an exit).

Europe in microcosm

Clearly investors should be concerned. Italy is the third biggest economy in the monetary union and one of its core members. Its departure would surely hasten the break-up of the whole euro project. What’s more, the political and economic tensions within Italy ahead of October’s referendum mirror those at work across the eurozone as a whole. In Italy the wealthy north makes up the industrial heartland which drives the economy, while the south is underdeveloped and poor. There is little enthusiasm for structural reforms, and throughout the country populist movements which promise to tear down the self-serving political establishment are rapidly gaining ground.

Italy is the wider eurozone in microcosm. In the EU as a whole, progress towards creating the political and economic institutions that could ensure the success of the single currency project have been comprehensively obstructed by narrow – but deeply entrenched – national interests. This failure to advance, and the economic hardships and sense of disempowerment that have resulted, has fueled the rise of populist political parties from Greece to Finland – parties that are challenging an increasingly distrusted political elite and questioning not just the status quo, but the whole European project. If Renzi wins come October, the eurozone has fresh hope. But if he fails, Italy fails, and very likely the eurozone fails too.

Housing in America

Comradely capitalism

How America accidentally nationalised its mortgage market

THE most dramatic moment of the global financial crisis of the late 2000s was the collapse of Lehman Brothers on September 15th 2008. The point at which the drama became inevitable, though—the crossroads on the way to Thebes—came two years earlier, in the summer of 2006.

That August house prices in America, which had been rising almost without interruption for as long as anyone could remember, began to fall—a fall that went on for 31 months (see chart 1).

In early 2007 mortgage defaults spiked and a mounting panic gripped Wall Street. The money markets dried up as banks became too scared to lend to each other. The lenders with the largest losses and smallest capital buffers began to topple. Thebes fell to the plague.

Ten years on, and America’s banks have been remade to withstand such disasters. When Jamie Dimon, the boss of JPMorgan Chase, talks of its “fortress” balance-sheet, he has a point. The banking industry’s core capital is now $1.2 trillion, more than double its pre-crisis level. In order to grind out enough profits to satisfy their shareholders, banks have slashed costs and increased prices; their return on equity has edged back towards 10%. America’s lenders are still widely despised, but they are now in reasonable shape: highly capitalised, fairly profitable, in private hands and subject to market discipline.

The trouble is that, in America, the banks are only part of the picture. There is a huge, parallel structure that exists outside the banks and which creates almost as much credit as they do: the mortgage system. In stark contrast to the banks it is very badly capitalised (see chart 2). It is also barely profitable, largely nationalised and subject to administrative control.

That matters. At $26 trillion America’s housing stock is the largest asset class in the world, worth a little more than the country’s stockmarket. America’s mortgage-finance system, with $11 trillion of debt, is probably the biggest concentration of financial risk to be found anywhere. It is still closely linked to the global financial system, with $1 trillion of mortgage debt owned abroad. It has not gone unreformed in the ten years since it set off the most severe recession of modern times. But it remains fundamentally flawed.

The strange path the mortgage machine has taken has implications for ordinary people, as well as for financiers. The supply of mortgages in America has an air of distinctly socialist command-and-control about it. Some 65-80% of all new home loans are repackaged by organs of the state. The structure of these loans, their volume and the risks they entail are controlled not by markets but by administrative fiat.

No one is keen to make transparent the subsidies and dangers involved, the risks of which are in effect borne by taxpayers. But an analysis by The Economist suggests that the subsidy for housing debt is running at about $150 billion a year, or roughly 1% of GDP. A crisis as bad as last time would cost taxpayers 2-4% of GDP, not far off the bail-out of the banks in 2008-12.

America’s housing system has always been unusual. In most countries banks minimise their risk by offering short-term or floating-rate mortgages. American borrowers get a better deal: cheap 30-year fixed-rate mortgages that can be repaid early free. These generous terms are made possible by the support of a housing-finance machine that funnels cheap credit to homeowners and, in doing so, takes on the risk, thereby shielding both the borrowers and the investors.

For decades lightly regulated thrifts did most of this lending. But in the 1980s they blew up due to a mixture of risky lending, inadequate capital and bad bets on interest rates. Between 1986 and 1996, over 1,000 thrifts were bailed out at a cost to taxpayers of about 3% of one year’s GDP.

The vacuum left by the thrifts was filled by the new technology of securitisation, which seemed, for a while, to make the risk vanish altogether. There are several steps. Mortgages are originated, or agreed, with millions of homeowners. The loans thus underwritten are then spruced up to look more attractive or realise some profits; for example sometimes insurance may be taken out against defaults, or the rights to “service” loans (collect interest payments) sold off. Next the loans are guaranteed and securitised. The bundles of bonds thus produced are then flogged to investors. After all this, derivatives contracts are created whose value is linked to these bonds.

The machine blew up in 2006-10 for a host of reasons, the most important of which was wild and sometimes fraudulent underwriting. There was a run on mortgage bonds and on the firms that issued or owned them. There have since been three big changes. 

The trouble with Gosplan
First, banks have partially withdrawn from the mortgage game after facing swathes of new rules and $110 billion of fines for misconduct. They still own mortgage-backed bonds and they still make home loans to wealthy folk, which they keep on their balance-sheets. But with the exception of Wells Fargo they are less keen on writing riskier loans in their branches and feeding them to securitisers. New, independent firms like Quicken Loans and Freedom Mortgage have filled the gap. They originate roughly half of all new mortgages.

The second big change is that the government’s improvised rescue of the system in 2008-12 has left it with a much bigger role (see chart 3). It is the majority shareholder in Freddie Mac and Fannie Mae, mortgage companies that were previously privately run (though with an implicit guarantee). They are now in “conservatorship”, a type of notionally temporary nationalisation that shows few signs of ending. Other private securitisers have withdrawn or gone bust. This means that the securitisation of loans, most of which used to be in the private sector, is now almost entirely state-run. Along with Fannie and Freddie, the other main players are the Veterans Affairs department (VA), the Federal Housing Administration (FHA) and Ginnie Mae, which helps the FHA and VA package loans into bonds and sell them.

In all, these five bodies own or have guaranteed $6.4 trillion of loans: a book of exposure three times larger than Mr Dimon’s balance-sheet. The FHA, an agency tasked with promoting home ownership, has tripled its guarantee book since the crisis. The mortgage bonds into which these entities bundle their loans are perceived by investors to be almost as safe as Treasuries; though they charge a fee for this protection, it is far lower than that which private companies that do not benefit from the backing of the state would have to charge if they were taking on the same risks. Thus they face no competition.

The last big change is the withering of the derivatives superstructure. The baroque instruments of the 2003-07 bubble, such as CDOs, CLOs and swaps on the ABX Index, have been stripped back after huge losses: trading activity has fallen by 90%. The mortgage machine is safer as a result. But even shorn of this amplifying mechanism, the machine is still connected to the broader world of global finance. American banks own 23% of all government mortgage bonds.

American officials who served during the crisis tell war stories about trying to persuade their counterparts in China and elsewhere not to dump all their mortgage bonds. As a result of their efforts foreign central banks, private banks and financial firms still hold 15% of all mortgage bonds; Barclays’ mortgage-bond holdings are worth 22% of the bank’s core capital. The rest are mainly owned by domestic investment funds and the Federal Reserve which, due to its asset-purchasing scheme, holds $1.8 trillion of government mortgage bonds, or 27% of the total.

This new credit machine has plenty of flaws. Almost everyone in the business worries that regulation of the new mortgage originators which funnel loans to the government-guarantee firms is too loose, for example; supervisors are looking at tightening up. But the biggest issue is the danger that sits with the state-run securitisers that magically transform risky mortgages into risk-free bonds. With a dearth of reliable market signals and a diminished profit motive, the risk appetite of the mortgage system is now entirely controlled by administrative fiat. There are at least 10,000 relevant pages of federal laws, regulatory orders and rule books.

These are meant to prevent another blow-up by screening out undesirable loans before securitisation. They stipulate the profile of the borrower (a debt-servicing-to-income ratio of more than 43% is a poor lookout) and, indeed, the dimensions of the house (if prefabricated, it must be at least 12 feet, or 3.6 metres, across). They define the documentation required. They specify the design of mortgages: balloon payments (whereby repayment of the principal is pushed back to the end of the loan period) are a no-no, as are some fee structures. They impose rules on counterparties: mortgage insurers, for example, must have over $400m of assets at hand. Although there are no government quotas for the volume of new loans there are soft targets.

Like water through cracks, risk still finds a way in. Federal law is silent on loan-to-value limits for borrowers, so this is one area where risky lending is booming, with a fifth of all loans granted since 2012 having LTV ratios of 95%, meaning homeowners are underwater if house prices fall by more than 5%. Most of these sit with the FHA. One big bank admits that it is selling at face value high-risk loans to the government that it expects will make a 10-15% loss due to homeowners defaulting.
My indecision is final
And all such rules are vulnerable to political pressure. Home-ownership rates have dropped to about 63% from a peak of 69% (see chart 4); many housing experts talk of an affordability crisis among the young and minorities. With Congress gridlocked and likely to remain so after the election, the mortgage machine is a largely off-balance-sheet way to funnel money to ordinary Americans, most of whom still want to own homes. Just as underwriting standards in the private sector gradually loosened over time before 2007, there are gentle signs of loosening evident today, too—rules on down-payments, for example, have been relaxed. Not yet frightening; but it never is, to begin with.

All the new rules are silent on the mortgage system’s purpose. One potential justification is simply to facilitate a liquid mortgage-bond market. By acting as a common guarantor, the state can ensure that mortgage bonds are homogenous and easy to trade ($220 billion-worth change hands every day). Another is to subsidise home loans for a broader political or social purpose.

In the absence of a grand design or clear political direction, the mortgage machine has assumed both roles.

One response to the new mortgage system is to leave it be. After all, the previous approach, in which private securitisers played a bigger role, was a disaster. Household debt is relatively restrained at the moment; measured by debt-service-to-income ratios it is 10% below the long-term average. Based on the post-war experience, housing-debt crises come only every 25 years or so; it is not yet time to worry about another one.

Leaving aside its fundamental irresponsibility, a course of inaction carries hard-to-quantify costs in the form of subsidies for borrowers. The securitisation industry believes there are reasons for not holding it to the same standard as the banks. But imagine that it were: that it had to carry the same level of capital as banks do and to make an adequate (10%) post-tax profit on that capital. The higher costs entailed give a sense of the scale of the current distortion. On this basis The Economist calculates the subsidy on mortgages to be running at $150 billion a year, 1% of GDP. (This estimate includes the impact of the Fed’s bond-buying on interest rates and the cost of tax breaks on mortgage-interest payments.)

And the status quo also means that, in the event of another crash, taxpayers would be landed with a big bill. How big? Consider a spectrum of scenarios. At one end, the cumulative mortgage-system losses are 10%, the same as the actual losses in 2006-14 according to estimates by Mark Zandi of Moody’s Analytics. At the other, cumulative losses on all mortgages are assumed to be 4.4%—the level the Fed used in its stress tests of the banks in May 2016. Adjusting for the pockets of capital in the system, and the profits made by some parts of it, both of which can help absorb losses, this means that the total loss for taxpayers if another crisis strikes would be $300 billion-600 billion, or 2-4% of GDP. Most of this would fall on Fannie, Freddie and the FHA, which would need to draw money from the government to pay out on the insurance claims made by investors.

Such a bill would hardly bankrupt America. But it would enrage it again. It is similar in size to the $700 billion TARP bail-out that Congress reluctantly passed in 2008. Lawmakers might be unwilling to pay for a repeat performance, especially with some of the benefit going abroad—and the mere possibility of their not stumping up would set the world’s financial markets a-jitter. If Congress signed off, a populist president might still be able to scupper the deal; the credit line through which Fannie and Freddie would be paid is governed by a contract between the Treasury and their regulator that comes under the executive. The catastrophic impact that a mortgage-bond default would have on the markets would almost certainly serve to ensure that the politicians did, indeed, act. But the capacity of American politics to disregard what used to seem almost certain is on the up these days.

How to waste a crisis
There is an alternative approach: force the mortgage machine to follow the same path the banks have.

It would have to recapitalise and raise its fees enough to offer an acceptable profit on that capital. The subsidy would fall. Administrative controls could be eased. The risk of loss could be passed into private hands, either by privatising the mortgage-securitisation firms or by allowing them to shrink, with private banks and insurers now able to compete on a level playing field. Using the same approach as the Fed’s bank-stress tests, the system would need about $400 billion of capital. The cost of American mortgages would rise by about one percentage point.

There are various proposals for reducing the government’s role in the system; the White House floated several in 2013, and there is a range of reform bills floating around Congress, the best of which is known as Corker-Warner. But no one is in a hurry to pass reforms that would result in higher mortgage rates at a time when the middle class is struggling. A lot of policy discussions obfuscate the basic issues, assuming either that mortgages are now much safer than they were in the past or that the mortgage-guarantee firms can be safer than the banks even though not subject to the same stringent capital rules.

The government has pragmatic reasons to procrastinate. The coupons it gets on money loaned to Fannie and Freddie count as income but their debt doesn’t end up on its books; that provides a nice fillip for the accounts. The status quo also lets it avoid confronting a noisy group of hedge funds taking legal action over the treatment of Fannie’s and Freddie’s shareholders in the bail-out. If the government were to recapitalise or restructure the mortgage firms, it would probably need to reach a settlement with the hedge funds or defeat them.

To be fair, some parts of the mortgage system are trying to find ways to push risks on to the private sector. Fannie and Freddie have written new “risk sharing” deals that take a slice of the risk on about $850 billion of bonds, and package it into securities that are sold to investors or swap contracts with reinsurance firms. But even if these measures did not look a little too like some of the opaque instruments that blew up in 2007-08 to be entirely comforting, they would be no substitute for proper reform.

So the trigger for the most recent crisis remains the part of the global financial system that has been least reformed. Mortgages are still the place where many of America’s deepest problems meet—an addiction to debt, the use of hidden subsidies to mitigate inequality, and political gridlock. In the land of the free, where home ownership is a national dream, borrowing to buy a house is a government business for which taxpayers are on the hook.

Central banking

The Jackson four

Should the Fed adopt India’s inflation target?

IN THE latter part of this week, monetary policymakers and theorists from around the world were due to attend the Jackson Hole symposium, 6,800 feet up in the mountains of Wyoming.

Many people—aggrieved savers and yield-hungry investors—probably wish they would never come back down. To their critics, central bankers seem strangely committed to two unpardonable follies: eroding the interest people earn on their savings and inflating the prices they pay at the shops.

It was, therefore, brave of one central banker—John Williams of the Federal Reserve Bank of San Francisco—to argue on August 15th that the Fed might need to raise its 2% inflation target or replace it with an alternative if it is successfully to fight the next downturn. Some economists favour an inflation target of 4%. This is not as outlandish as it sounds. Indeed, the notion that new circumstances require a new target may appear quite run-of-the-mill to central bankers from the developing world who are taking part in the symposium.

Much criticism of the West’s central bankers rests on the myth that they are wholly responsible for rock-bottom rates. In fact, they seek the highest rates the economy can bear, but no higher.

When the economy is at full strength, they want a “neutral” (or natural) rate that keeps inflation steady, neither stimulating the economy nor slowing it. When the economy is overheating, they want a rate above neutral. And when the economy is weak, they want one below it. The neutral rate (r* in economists’ algebra) thus provides a vital reference point for their policy. As such, it exercises considerable influence over central bankers. But they, importantly, exercise precious little influence over it.

According to economic theory, the neutral rate reconciles the eagerness to invest and the willingness to save when the economy is in full bloom. As such, it reflects the productivity of capital, the promise of technology and the prudence of households, none of which are variables chosen by monetary officials. The neutral rate cannot be observed directly. But Mr Williams and a Fed colleague reckon it has fallen persistently: r-star (as he calls it) is close to zero, or about two percentage points lower than it was in 2004.

If r-star is lower than it was back then, the Fed’s policy rate must also be lower to be equally stimulative. That means today’s rate (of between 0.25% and 0.5%) is not as lax as it looks. Leo Krippner of the Federal Reserve Bank of New Zealand estimates that American monetary policy today is already as tight as it was in July 2005, when the federal funds rate stood at 3.25%, having been raised nine times.

The question preoccupying most Fed-watchers is how much tighter policy will get in the next year or two. Mr Williams raises a different concern: how much looser can policy get during the next downturn. If the Fed sticks to its current inflation target of 2%, a policy rate of 0% would translate into a real cost of borrowing of minus 2% (because the money debtors repay will be worth less than the money they borrowed). That may not be low enough.

Such a rate would be only about two percentage points lower than Mr Williams’s estimate of the neutral rate. Raising the inflation target to 4%, say, would allow real interest rates to drop about four percentage points below neutral if necessary. (This is not the only reform idea.

Another is targeting the trajectory of nominal GDP, which reflects both economic growth and price inflation; that might result in higher inflation when growth was weak and low inflation when growth was strong.)

But even if a 4% target is desirable, would it be feasible? The Fed has struggled to reach its current target quickly or consistently. What makes anyone think it could hit a higher one? One answer is that a higher target would free the central bank from a “timidity trap”, as Paul Krugman of the New York Times calls it. In such a trap the central bank sets its goals too low, and paradoxically falls short of them. A credible central bank might cut rates to zero and promise 2% inflation. If it is believed, inflation expectations will rise and the anticipated real cost of borrowing will fall to minus 2%. But if the economy actually needs a real rate of minus 4% to revive, spending will remain too weak, economic slack will persist and inflation will ebb, falling under target. Conversely, if the central bank promises 4% inflation, its pledges will be both believed and fulfilled.

Shooting r-star
Western policymakers dislike tinkering with their inflation targets. But in the wider universe of central banks, periodic revisions are no big deal. Indonesia sets its targets for a three-year period, as does the Philippines, Turkey and South Korea. This flexibility need not destroy a central bank’s sound-money credentials: South Korea’s inflation is even lower than America’s.

Although a target centred on 4% sounds scandalous to rich-world central bankers, it is not unusual elsewhere. Indonesia pursues one. Brazil’s inflation target is 4.5%. India is lowering its target from 6% last year to about 4% for the future. The committee recommending that figure was chaired by Urjit Patel, who will be the Reserve Bank of India’s next governor.

One advantage many emerging economies enjoy over richer ones is a higher r-star, thanks to faster rates of underlying growth and inflation, as low local prices converge towards higher international prices. That gives their central banks more room to cut interest rates in the face of a downturn. Indeed, it is hard to think of any catch-up economy that has remained stuck at zero rates.

If Mr Patel succeeds in his new job and the Fed embraces reform, America’s inflation target may one day resemble India’s. But India will still worry more about overshooting its target than undershooting it, and America will still probably harbour the opposite set of concerns.

Their inflation targets may match, but their r-stars will not be aligned.

What Are The Takeaways From Janet Yellen's Speech For Gold Investors?

Hebba Investments

The latest COT report surprisingly showed a net increase in speculative bulls despite a drop in the gold price which was negative.
Yellen's speech was a bit hawkish but in it she introduced some surprising inflationary measures as future monetary policy tools.
Fed Vice Chair Fischer is pushing one or two rate hikes if the data supports it and thus next week's jobs report is extremely important.
With positioning still very bullish and a critical catalyst coming in Friday jobs report we hold our core gold positions but wish to wait further before re-establishing sold positions.
The latest COT report showed little movement in trader positions before the Yellen. But since this report only included positions as of Tuesday, it didn't include Wednesday's bear raid and trader responses to Ms. Yellen's speech on Friday. Nevertheless, we saw an increase in speculative gold longs (which surprised us), a decrease in speculative shorts, and also a decrease in the gold price - which is a bit unusual as the gold price tends to follow the speculative money during the COT report week. That means that despite positive speculative flows there's a bit of selling that is over and above these flows and causing a drop in the gold price.
Finally, we will comment on our thoughts on Ms. Yellen's speech and its implications for the gold price. We will give our view and will get a little more into some of these details but before that let us give investors a quick overview into the COT report for those who are not familiar with it.
About the COT Report

 The COT report is issued by the CFTC every Friday, to provide market participants a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. In plain English, this is a report that shows what positions major traders are taking in a number of financial and commodity markets.
Though there is never one report or tool that can give you certainty about where prices are headed in the future, the COT report does allow the small investors a way to see what larger traders are doing and to possibly position their positions accordingly. For example, if there is a large managed money short interest in gold, that is often an indicator that a rally may be coming because the market is overly pessimistic and saturated with shorts - so you may want to take a long position.

The big disadvantage to the COT report is that it is issued on Friday but only contains Tuesday's data - so there is a three day lag between the report and the actual positioning of traders. This is an eternity by short-term investing standards, and by the time the new report is issued it has already missed a large amount of trading activity.
There are many different ways to read the COT report, and there are many analysts that focus specifically on this report (we are not one of them) so we won't claim to be the exports on it.
What we focus on in this report is the "Managed Money" positions and total open interest as it gives us an idea of how much interest there is in the gold market and how the short-term players are positioned.
This Week's Gold COT Report
This week's report showed an increase in speculative gold longs and a decrease in speculative shorts with longs increasing by 6,633 contracts and shorts closing out 4,645 contracts on the week. Despite the positive increase in net positions which usually is paired with an increase in the gold price, we actually saw a slight drop in the gold price - suggesting that speculative traders boosting long positions wasn't enough to counter the selling in gold from other entitites.
Moving on, the net position of all gold traders can be seen below:

The red-line represents the net speculative gold positions of money managers (the biggest category of speculative trader), and as investors can see, speculative traders have slightly pulled back from all-time high positions are now net long by around 265,000 contracts. Not much of a pull-back yet in gold or in gold sentiment as speculative traders remain extremely bullish.

As for silver, the action week's action looked like the following:
The red line which represents the net speculative positions of money managers, continued its pullback as speculative silver traders cut their long positions and increased their short positions.
Earlier in the week, we published a piece that showed extremely poor silver demand from bullion investors as US Mint sales of silver eagles have been very weak - if speculative demand from paper silver investors doesn't keep up we could see a sizable drop in silver under $18 or $17 dollar level.
Our Take on Janet Yellen's Jackson Hole Speech
We would be remiss to write an article on gold and not at least mention Yellen's Jackson Hole speech (see the transcript here), which is generally the most anticipated "Fed Speak" of the year. In our opinion her speech was a bit hawkish (which is what we expected) because she did mention that the data was much improved and "…in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months."
That was further emphasized by Fed Vice Chair Stanley Fischer as he put the focus on next week's August jobs report and forward data, in an interview with CNBC. In the interview, Fischer said that Yellen's comments were consistent with a September rate hike and possibly two hikes this year, but the Fed won't know the course of normalization until it sees the data.
Takeaway #1: Next Friday's Non-Farm Payrolls report will be extremely important in determining the odds of a September rate hike.
Also, Ms. Yellen mentioned something very interesting in terms of future potential monetary policy (emphasis ours):

…future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets. Beyond that, some observers have suggested raising the FOMC's 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting.
Purchasing alternative assets, increasing inflation expectations, and price-level targeting (i.e. injecting money until GDP rises) are all extremely dovish measures. Ms. Yellen caveats the statement by saying the "Fed isn't actively considering these tools", but we don't buy it as central bankers tend to mislead (the Bank of Japan drove interest rates negative a week after denying they would ever consider it) and if they weren't at least being discussed then why mention them at all?
What this should mean for investors that the "Fed Put" is even greater than it was before the speech as the next crisis could mean we see the Fed publicly buying corporate bonds and stocks to directly inject money into the system. If anything, this suggests to us that the next crisis will be the opposite of what policy makers are protecting against as markets tend to surprise - thus expect inflation and not deflation.
What This Means for Investors
The COT report was little moved for the week though we do note that while speculative investors increased net bullish positions the gold price dropped, which is bearish as it usually rises with speculative net position increases. This suggests there's a bit of weakness behind the scenes in the physical market and speculative traders are not strong enough to move the price higher. Of course, the report closed on Tuesday and thus doesn't include the later week moves in gold that drove it down to around $1320.

But the most important event in the gold market occurred on Friday as Janet Yellen gave her widely anticipated Jackson Hole policy speech. The speech was a bit hawkish but may have given investors a hint on the direction of future Fed fire-fighting maneuvers as she mentioned policy options such as purchasing "alternative" assets (think stocks and bonds) and increasing the inflation target from 2% to higher levels - all gold positive.
Finally, Vice Chair Stanley Fischer came out extremely hawkish and suggested the potential for two rate hikes and made next Friday's payrolls report extremely important as if it's a strong number then expect a September rate hike. We are of the opinion that the Fed wants to raise interest rates and will look to do so at the next practical opportunity.
While fundamentally raising or lowering interest rates by themselves is agnostic for gold as gold cares about the real rate and not the nominal interest rate as evidenced by gold rising in the rising interest rate environments (e.g. the 1970's and early/mid 2000's), the current narrative is that traders sell gold on the potential for rising rates and vice versa.
Thus we are still extremely cautious in gold as we are a bit worried about next week's job report being positive and knocking gold down, but we maintain our core positions in gold. But we aren't looking to re-establish any of our sold gold and silver positions just yet until we see more of a pullback in the metals or a bad jobs report and thus we think investors should hold off or lighten up on gold positions in the ETF's and miners such as the SPDR Gold Trust ETF (NYSEARCA:GLD), ETFS Physical Swiss Gold Trust ETF (NYSEARCA:SGOL), iShares Silver Trust (NYSEARCA:SLV), and miners such as Randgold (GOLD) and Barrick Gold (NYSE:ABX).
At $1320 we're getting more interested in buying back some of our sold gold positions but not quite yet as we await next week's job report.

The Fed BS
8-26-2016 3-29-32 PM

Markets opened the trading day Friday with some confusion over just what to make of different takes between Fed Vice-Chair Fischer’s and Chair Yellen’s comments regarding monetary policies going forward. Initial reactions to these remarks were two sided but in the end settled in a state of confusion.

What made it so?

The view was recent economic data was trending positive enough to bear an interest rate increase in September. For many of us this is more than just a little amusing given more serious economic weakness as, weak GDP and consumer data. From my view the ongoing disconnect between obviously weak economic data (GDP and persistent unemployment data among others) remain more than just a little disturbing. In fact, they hint at deliberate data manipulation and cherry-picking of data making results fit goals rather than being more objective. Bottom line, in an election year political demands easily can interfere making results more seem spurious to many.

Is the Fed looking for an excuse to raise interest rates?

This might be so since even they might acknowledge these have been held too low for too long.   
The Fed acknowledges even it has no idea what the future portends as the “fan chart” (below) displays the broad range it forecasts for the path ahead.

8-26-2016 3-43-09 PM

Below is the heat map from Finviz reflecting those ETF market sectors moving higher (green) and falling (red).

Dependent on the day (green) may mean leveraged inverse or leveraged short (red).

8-26-2016 3-44-00 PM

Volume rose Friday to complete an ultra-light volume week. Breadth per the WSJ was mixed to negative.
8-26-2016 3-44-36 PM

12-17-2015 9-04-44 PM Chart of the Day
8-26-2016 3-45-08 PM USO
HI/LO Indicators

As we enter the final week of the summer of 2016, the following is a list of ETFs with technical overbought or extended valuations.
 12-12-2014 2-32-30 AM Bull bear twitte
These numbers signify in the left column (buy to close short) or right column (sell to close long).
 8-26-2016 5-22-02 PM daily
8-26-2016 5-25-18 PM weekly 
8-26-2016 5-29-48 PM Monthly

Charts of the Day















































    The NYMO is a market breadth indicator that is based on the difference between the number of advancing and declining issues on the NYSE. When readings are +60/-60 markets are extended short-term.


    The McClellan Summation Index is a long-term version of the McClellan Oscillator. It is a market breadth indicator, and interpretation is similar to that of the McClellan Oscillator, except that it is more suited to major trends. I believe readings of +1000/-1000 reveal markets as much extended.


    The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge". Our own interpretation has changed due to a variety of new factors including HFTs, new VIX linked ETPs and a multitude of new products to leverage trading and change or obscure prior VIX relevance.

Make of conditions what you will.

For us markets are living on borrowed time. But that’s if the old rules of valuations and conditions hold true.

That said, these aren’t even your big brother’s markets.

Let’s see what happens.