Yellen on Inflation

Doug Nolan

Global Markets rallied sharply this week. The DJIA rose 223 points to a record 21,638. The S&P500 gained 1.4% to a new all-time high. The Nasdaq100 (NDX) surged 3.2%, increasing 2017 gains to 20.0%. The Morgan Stanley High Tech Index rose 3.4% (up 24.6% y-t-d), and the Semiconductors surged 4.7% (up 21.8%).

Emerging markets were notably strong. Equities rallied 5.0% in Brazil, 5.5% in Hong Kong, 5.1% in Turkey, 2.5% in Russia, 2.2% in Mexico and 2.1% in India. The Brazilian real gained 3.2%, the Mexican peso 3.0%, the South African rand 2.7% and the Turkish lira 2.3%. Global bond markets also rallied. Yields (local currency) dropped 27 bps in Brazil, 18 bps in South Africa, 16 bps in Turkey and 22 bps in Argentina. Here at home, five-year Treasury yields dropped eight bps (to 1.87%). U.S. corporate Credit also enjoyed solid gains. Across global markets, it appeared that short positions were under pressure.

Markets reacted with elation to Janet Yellen’s Washington testimony – widely perceived as dovish. In particular, the chair’s timely comments on inflation were cheered throughout global securities markets. A headline from the Financial Times: “Fed Chair Yellen’s Inflation Concern Buoys Markets.” And Friday afternoon from Bloomberg: “S&P 500 Hits Record as Inflation View Turns Iffy”.

July 12 – Financial Times (Sam Fleming): “Janet Yellen acknowledged… that the US’s persistently subdued inflation could raise questions about the Federal Reserve’s current path of gradually raising interest rates and vowed to watch prices ‘very closely’ for signs they were stagnating. The Fed chair insisted it was ‘premature’ to second guess policymakers’ determination inflation was slowly headed to the central bank’s target of 2%. But her note of caution helped spark a rally in US Treasuries and equities, with investors hopeful Ms Yellen would keep the Fed’s easy money stance for longer… Ms Yellen was broadly positive about the economy’s recent performance…, stressing there had been a rebound in household spending over recent months and the Fed was still anticipating further rate increases. But she also said she was studying the low inflation numbers for signs that short-term drags on prices may not be the only factors holding it back. She added that rates may not need to be lifted a lot more to get back to a neutral stance. ‘We are watching inflation very carefully,’ Ms Yellen said... ‘I do believe part of the weakness in inflation reflects transitory factors, but well recognise that inflation has been running under our 2% objective, that there could be more going on there.’ Analysts said Ms Yellen’s remarks marked a small but significant change of thinking, putting the Fed’s path of gradually pulling back on economic stimulus in question. ‘Yellen’s statement today reveals that the Fed isn’t as sure about inflation as they led us to believe,’ said Luke Bartholomew, investment strategist at Aberdeen Asset Management.”

It’s fair to say that the whole issue of “inflation” confounds the Fed these days. Despite antiquated analytical frameworks and econometric models, the Federal Reserve is showing zero inclination to rethink its approach. At the minimum, objective policy analysis would recognize today’s nebulous link between monetary stimulus and consumer price inflation. Rational thinking would downgrade CPI as a policy guidepost, especially relative to indicators of broader price and financial stability. Still, consumer prices rising slightly below 2% have somehow become central to the argument for maintaining aggressive monetary accommodation.

The nature of economic output has fundamentally changed – from mass-produced high tech hardware, to limitless software and digitalized content, to endless pharmaceuticals and wellness to energy alternatives to, even, the proliferation of organic foods - just to get started. There is today essentially unlimited capacity to supply many of the things we now use in everyday life (sopping up purchasing power like a sponge). Much of this supply is sourced overseas, which further diminishes the traditional relationship between domestic monetary conditions and consumer price inflation.

These dynamics have unfolded over years and are well recognized in the marketplace. To be sure, ongoing tepid consumer price inflation seems to be the one view that markets hold with strong conviction. So when Yellen suggested that below target inflation would alter the trajectory of Fed “normalization,” the markets immediately took notice. When she again referred to the “neutral rate” and implied that the Fed was currently near neutral, this further signaled a Fed that has developed its own notion of what these days constitutes “normal.” Throw in that the FOMC plans to pause rate increases while gauging market reaction to its (cautious) balance sheet operations, and it has become apparent to the markets that the Fed won’t be pushing rates much higher any time soon.

We’ll wait to see if Fed officials push back against the market’s dovish interpretation of Yellen testimony. There’s certainly no conundrum. If the Fed is confused that financial conditions have loosened in the face of “tightening” measures, look in the mirror. Chair Yellen needed to choose her words carefully, especially on the subject of inflation. The markets were near all-time highs, with what has likely been a decent amount of hedging/shorting over the past month. An upside breakout risks a bout of destabilizing speculation. At the same time, there were early indications of fledgling risk aversion. Global yields had recently jumped. Weakness was notable in the periphery debt markets (i.e. Italy, EM), and even U.S. corporate Credit was hinting vulnerability.

Importantly, there was heightened market concern that a concerted effort was underway to begin removing central bank accommodation – that booming markets and stubbornly loose financial conditions might force central bankers to adopt more aggressive tightening measures.

Understandably, the markets will interpret a dovish Yellen – especially the nuanced language on the topic of inflation – as rushing to the markets’ defense. The view that the Fed won’t tolerate even a modest market pullback is, again, further emboldened. And quickly global markets will return to the view that central bankers may talk “normalization,” while their overarching anxiety for upsetting markets has diminished little.

July 12 – Bloomberg (Vivien Lou Chen): “Fed Chair Janet Yellen says that in looking at asset prices and valuations, the central bank is ‘not trying to opine on whether they’re correct’; instead, policy makers are assessing the risk of potential spillovers. As asset prices rise, there hasn’t been a substantial increase in borrowing, Yellen said. [The] financial system is strong and resilient.”
I assume chair Yellen is referring to U.S. non-financial and non-government borrowings. Clearly, central bank Credit and government borrowings have expanded spectacularly around the globe. I suspect as well there has been a major expansion in speculative leveraging and securities Credit at home and abroad.

Georgia Senator David Purdue: “Thank you for being here and for your service. I just have two quick questions. I’m very concerned about global debt. The Institute of International Finance recently reported that their estimate of total global debt is $217 trillion, or more than 300% of global GDP. Do you agree with that?”
Chair Yellen: “So, I haven’t heard that number. That could be. I don’t have that number.”

Purdue: “Of that, $60 trillion is estimated to be sovereign debt. We have about $20 trillion of the $60 trillion. With that as background, the four large central banks also have their largest historic balance sheets. Japan, China, EU and US have collectively close to approaching $20 trillion now of balance sheet size. As you talk about reducing the size of the Fed’s balance sheet, are you coordinating with these other central banks and looking at emerging market debt - particularly the $300 billion that’s coming due by the end of 2018 - relative to the size of your balance sheet here in the United States?”

Yellen: “I wouldn’t say coordinate. We try to make sure we meet regularly and discuss our policy approaches; to make sure that central banks understand how we are looking at economies and policy options. I think the major central banks understand the approach that others are taking. But trying to ask in an aggregate sense how much debt is outstanding is something we’re not doing. Our economies are in rather different situations. While we all encountered weaknesses that were sufficiently severe that Japan, the ECB, the Bank of England, the United States, we all resorted to purchases of longer-term assets to support growth. It leaves the Bank of Japan and the ECB.”

Purdue: “Are you concerned about so much of that [debt] denominated in dollars today?”

Yellen: “It is a risk. A significant amount of that is in China, but that’s not the only country where there are substantial corporate dollar-denominated debts. And certainly that is a risk that we have considered that affects the global economy.”

Senator Bob Menendez: “Let me ask you finally, how does—we see high rising levels of household debt, widening inequality, a neutral interest rate at historically low levels. To me, it’s critical that the Fed has the ability to respond in the event of another economic decline. How does below target inflation impact household debt? And what signs do you see of inflation coming close to the Fed’s 2% target, let alone exceeding it by dangerous amounts?”
Yellen: “As I said, I think the risks with respect to inflation are two-sided. But we’re very aware of the fact that inflation has been running below our 2% objective now for many years, and we’re very focused on trying to bring inflation up to our 2% objective. That’s a symmetric objective and not a ceiling. We know from periods [when] we’ve had deflation, which of course we don’t have in this country. But that is something that has a very adverse effect on debtors and can leave debtors drowned in debt. Now, we don’t have a situation nearly that serious. But it is important when we have a 2% inflation objective to make sure that we achieve it and we’re focused on doing that.”

Yellen stated during that the Fed’s inflation mandate is “symmetrical.” Yet it’s unimaginable that the FOMC would keep monetary conditions extraordinarily tight for nine years in response to CPI modestly above its 2% target?

It’s by this point abundantly clear that contemporary monetary management exerts major direct influences on the structure of asset prices, while having dubious effect on aggregate consumer prices. This now discernable dynamic creates a momentous dilemma for central banks. Especially after the worldwide adoption of the Bernanke doctrine, it’s fundamental to their approach that central banks retain the power to inflate out of trouble as necessary. Why fret debt accumulation, speculation and asset price Bubbles when central banks can always inflate the general price level, thereby reducing debt burdens and asset overvaluation?

Central bankers have a penchant for speaking in terms of “fighting the scourge of deflation.” More specifically, they view inflation as the indispensable mechanism for reflating systems out of the consequences of debt and asset Bubbles. If central bankers were to admit they don’t control “inflation,” then their policy doctrine of promoting reflationary debt growth and higher asset prices turns spurious.

It has been my longstanding position that it’s not possible to inflate out of major Credit and asset Bubbles. As we’ve witnessed for years now, central bank stimulus fuels self-reinforcing speculative excess, with a resulting accumulation of speculative leverage and securities-related Credit more generally. At the same time, years of abundant cheap global liquidity work to feed overcapacity and attendant downward price pressure on many things. Rampant inflation within the Financial Sphere nurtures pricing vulnerabilities and instability throughout the Real Economy Sphere. Bubbles Inflate Only Bigger.

As such, if one accepts the reality that central banks don’t control inflation, the policy course of repeatedly inflating serial Bubbles can be viewed as risking eventual catastrophic policy failure. There’s simply no escaping the day of reckoning. This analysis certainly applies to China. Led by strong lending ($214bn), June growth in Total Social Financing jumped to $263bn. This puts first-half non-government Credit growth at $1.65 TN (up 14% from last year’s record pace), consistent with my expectation for total Chinese Credit growth this year to exceed $3.5 TN.

Along with Yellen’s testimony, China developments were likely a factor in this week’s global risk market rally. The view is taking hold that Chinese officials have at least temporarily pulled back from tightening measures, perhaps in preparation for this autumn’s 19th National Congress of the Communist Party of China.

July 12 – Wall Street Journal (Grace Zhu): “Chinese banks extended higher-than-expected volume of loans last month even as growth in the money supply continued to slow amid Beijing’s efforts to reduce leverage in its financial system. New yuan loans issued by Chinese banks surged to 1.54 trillion yuan ($226.38bn) in June, up from 1.11 trillion yuan in May… The volume was well above the 1.3 trillion yuan forecast by economists… June is typically a high point for new credit from Chinese banks’ as loan officers rush to meet quarterly targets. Beyond that, demand for credit from households—mostly for mortgages in the hot property market—remained strong, and companies too turned to banks for loans, instead of issuing bonds.”

July 12 – Financial Times (Gabriel Wildau): “China’s central bank injected $53bn into the banking system on Thursday, the latest sign that policymakers have eased up on a fierce deleveraging campaign that has caused turmoil among lenders in recent months. President Xi Jinping told the politburo in April that ‘financial security’ was a top policy priority for the year. That led the central bank to tighten liquidity, while the ambitious new banking regulator unleashed a ‘regulatory windstorm’ that sent shockwaves through the banking system. The storm appears to be passing, as the People’s Bank of China has become more generous with cash injections while the China Banking Regulatory Commission has delayed implementation of a significant new directive. ‘There are clear signs in recent weeks of monetary and supervisory tightening being eased,’ Tao Wang, co-head of Asia economics at UBS in Hong Kong, wrote…”

“You Look Like I Need a Drink”: Comments Before the National Association of Chain Drug Stores

By Richard Fisher

I did indeed come straight from Beijing and admit to being jet lagged, though this great resort and the hospitality you and your association have shown me is a very nice way to recover.

Here is a little known fact: I have been going to China since 1948. How could that be? Well, my parents were on the second-to-last ship to leave Shanghai, the SS President Wilson, before Mao’s forces closed the ports. They had been living in the Peace Hotel while my dad was on business there. I was born six months later in Los Angeles. So, like so many things we have here in the U.S., I was manufactured in China!

Now to more serious things.

Six hundred miles west of Norway there is a communications station on Jan Meyen Island where 17 hearty members of Norway’s Special Forces tracked Soviet submarines. If you read Tom Clancy’s Hunt for Red October, you would know it as “Loran C”. If you played the video game Tomb Raider, you would recall that Lara Croft – played by Angelina Jolie in the film version – visits Jan Meyen in search of Thor’s Hammer, considered the most awesome weapon in Norse mythology, capable of leveling mountains and performing the most heroic of feats.

When you arrive on the island you are greeted with this sign: Translated it reads:

Theory is when you understand everything but nothing works;

Practice is when everything works but nobody understands why.

At this station, theory and practice are united: nothing works and nobody understands why.

 Jim  (Whitman) asked me to speak to you this morning to try to explain why, in the world in which we live today, what we are used to working doesn’t. And why nobody seems to understand why.

 I will give it my best shot.
“You Look Like I Need a Drink!”

Let’s start with politics. The political scene has changed enormously since I received the invitation from Jim to speak to you today. Then, it was a given that Hillary Clinton would become the 45th president of the United States and that fiscal, regulatory and government policy would follow conventional form. In what was a shock to some (but not to this speaker), Donald Trump was elected on the premise that he would “drain the swamp” in Washington and turn the tables on the status quo. This has engendered enormous angst among those who had banked on business as usual. And great hope among those who worried that the magnificent machine that is the U.S. economy has been in decline.

The former group, those accustomed to the intoxicating ambrosia of the status quo, regard President Trump with a reaction not unlike that of country singer Justin Moore’s title song “You look like I need a drink!”
The “Orange Swan” and “Half-wits”

The latter, especially sober business leaders, financiers and market operators, have turned the term “Black Swan” on its head. In the parlance of finance, a “Black Swan” is an unforeseen event that shocks the market place and leads to severe negative reaction.

Business operators looked at the President’s agenda of deregulation, pledges of tax cuts and reform, his cabinet appointments and Supreme Court nominee, and his general disposition toward curbing the intrusion of government on freedom of the “animal spirits” and saw what I will call in deference to the Candidate Trump’s then hair color, an “Orange Swan” – a welcome surprise to the upside.

I’ll put this in perspective with my favorite story told by Ronald Reagan. During the 1984 presidential campaign, President Reagan came to Dallas. My then father-in-law, Republican Congressman Jim Collins, a close friend of the president’s, let me join him for a small gathering with the President at the Collins’ ranch. Reagan told us a story of an Irish farmer named Paddy O’Toole who is visited by an Inspector from the Welfare and Work Security Ministry.

“Tell me, Paddy,” the official asked, “ how do you compensate your workers?”

“Well,” says Paddy, “ I pay the field workers 300 a month plus room and board and an annual bonus based on our profits.”

“Ah, Paddy! Good man! That’s way above minimum wage and very generous. Excellent!” says the bureaucrat. “And your processors?”

“I pay them 600 monthly and also provide them room and board plus a slice of profits.”

“Brilliant! That’s way above the norm too. You are indeed a good man, Paddy,” says the Inspector. “Now tell me, are there any others?”

“Oh yes,” says Paddy. “There is the half-wit. He works the longest hours of all, shoulders all of the farm’s liabilities and risks, clears about 30 a month, gets to down a fifth of whiskey a fortnight, and gets to sleep with me wife on the weekends if he is up to it.”

“Paddy, that is outrageous!,” says the Inspector. “ It is completely unacceptable. It violates every rule, regulation and law of the land. I demand to see the ‘half wit’ immediately!”

“Laddy,” Paddy replies, “You’re lookin’ at ‘im.”

One could say that the “half-wits” that the elite scolds tend to look down upon revolted in the last election against taxes that strip them of what they earn by the sweat of their brow and the strength of their back, regulations that dictate their behavior where they work and live and study and worship and tend to their medical needs, and monetary policy that has crippled their savings and spending power, policy which I will turn to shortly.
Phil Gramm’s Verification

If you are looking for statistical verification of the malaise that was afflicting the U.S. economy, go back and read last Thursday’s excellent op-ed by former Senator Phil Gramm and Michael Solon in the Wall Street Journal. They documented the fact that “Economic growth during the (past eight) years averaged an astonishingly low 1.47%, as compared with the 3.4% average throughout all of the post-war booms and busts before 2009.” They pointed out that in the recovery from the recent recession, “real growth in gross domestic product – our nation’s output – averaged 2.1% per year, less than half the 4.5% average during previous recoveries of similar duration.”

Mind you, these anemic growth rates followed a devastating downturn that crippled employment and depleted the savings of the vast majority of Americans. As we approached the election, we were indeed in the throes of what many economists described as “secular stagnation”.

Small wonder that voters took a risk with a change agent who offered hope of relief. And with change agents that ran the table not just in the Electoral College but in the lower and upper houses of Congress, governors mansions and state legislatures, 27 state attorneys generals offices and a majority of counties across the land.  The choice was between a candidate and a platform advocating more of the same and one who offered to provide relief by changing gears entirely.

Changing the gears of a ship of state as large as ours is not easy. Yesterday, the Wall Street Journal and NBC released a poll with a startling statistic: when asked if government should do more – more – to solve problems and help people needs, 57% of the respondents said “yes”, while less than 49% said “no”, that initiative should come from individuals themselves and businesses.

In the same issue of the Journal, there is another poll reported, this one from the Washington Post, that declares President Trump “the least popular president in modern times.” And yet if you read the fine print of those poll results, while almost half of those polled said they had voted for Mrs. Clinton in November, only 40% said they would do so again. Despite the President’s high disapproval rating and much-reported problems in getting things done in his first 100 days, he would still win the election if it were held today.
Polls and Ken Arrow’s Forecasts

You can’t take too much comfort in of polls; they are hardly the best predictors. We learned this with BREXIT, as well as with the pre-election polls of our own election. I monitor polls with a cynical eye, just as I do economic forecasts. They are as much art as they are presumably scientifically precise, and they can lead to misleading conclusions if taken at face value.

The best story I can share with you on this front is an iconic one in central bank circles. 

One of the greatest modern economists was Kenneth Arrow. During WWII he served as a weather forecasting officer in the U.S. Army Air Corps, assigned the difficult task of producing month ahead weather forecasts as the date for Omaha Beach approached. A thorough man, he had his team review the accuracy of his forecasts: they confirmed statistically that they were no more accurate than random rolls of dice. So he cabled the High Command, to be relieved of this seemingly futile duty. Arrow’s recollection of his superior’s response was priceless: “ The commanding general is well aware that the forecasts are no good. However, he needs them for planning purposes.”

The value of immediate polls, like economic forecasts, may be questionable but I do think what we can surmise by reading the entrails is that the American people know deep in their gut that we have been drifting for too long into complacency in accepting what some would call a “nanny state” and that as much as we have been getting used to it, it somehow runs against the American fiber of individualism and self-reliance. What I saw in this last election was a desire to have someone – anyone – pull us off the path of continued decline.

One might say that voters were looking for a version of Thor’s Hammer, a crude force capable of leveling bureaucratic mountains and performing the most heroic feat of putting us back on a course of growth and expansion, however great the risks.

Risks to Consider

To be sure, there are indeed great risks. I won’t reiterate them here with the exception of saying that one that ranks at the top of my worry list is that of withdrawing from, rather than improving the present world order.

I am ardent believer in American exceptionalism. I believe the U.S. is indeed a uniquely successful experiment and that we have been an example to the world. Which means we have an obligation to continue being exemplary. I believe there is a need to update almost all of the post-WWII structures, ranging from the Bretton Woods institutions, the U.N., NATO and other strategic pacts, multilateral and bilateral, which we have led, and trade agreements like NAFTA, which I spent four years implementing as Deputy U.S. Trade Representative, to take account of the changes that have occurred since the fall of the Soviet Union, the rise of China, the growing nuclear threat of North Korea, the information-technology and cyber revolution, and other phenomena that have changed the global economy and the practice of politics and diplomacy, including ubiquitous social media and even Saturday Night Live.

But making needed changes will require delicate diplomacy, lest we unleash the destructive ghosts of isolationism and protectionism.   

Let us hope that the new Administration and the Congress will guide us through much-overdue changes with aplomb rather than bombast.
Mexico Redux

Being here in Arizona, I have special concern with the delicate subject of Mexico, a nation of 120 million people who until recently delivered one of the best performing economies in our hemisphere, are our nation’s second largest trading partner and share, by far, the most important trading relationship with the most prosperous state in the union, my home state of Texas. It will take a clever hand to update our relationship with Mexico without destroying it and giving rise to a U.S. equivalent of Europe having Turkey on its southern border.

By the way, I assume you have all heard the quip: “Of course a Wall works. China built one and they haven’t seen a Mexican in over 2,000 years!”

All humor aside, pray that the new leadership corrects whatever imbalances exist in U.S. global trade and other commitments without overturning the apple cart.
Churchill’s Dictum

Last comment on this front before turning to the challenge of present financial markets and monetary policy: should you be tempted to give in to all engrossing angst over the change agent that has been elected to lead the American people, remember Churchill’s insightful dictum: “Americans always do the right thing… after they have tried everything else.”
Monetary Policy: The Good and the Bad

Now to the economy and markets. As president and CEO of the Federal Reserve Bank of Dallas, I participated in Federal Open Market Committee (FOMC) deliberations from 2005 to 2015. Recall that despite my concerns and dissents, the FOMC cut overnight rates to zero and through Quantitative Easing, expanded the holdings of the Fed’s balance sheet from less than $900 billion when I joined to almost $4.5 trillion presently, increasing the duration of the holdings in the portfolio to six years from what was typically the shortest of tenors.

The reason for doing so was to create what Ben Bernanke summarized as a “wealth effect” that would lift financial markets to the benefit of the economy. When you cut rates to the “zero bound”, then flatten the yield curve by purchasing trillions of dollars of mortgage backed and U.S. Treasury securities, you are signaling to investors that they can literally discount future cash flows of the assets they invest in to infinity. And sure enough, with the FOMC having bought in $1.75 trillion worth by the end of February 2009, the equity market turned the first week of March and cap rates for properties began to plummet.

That was all to the good for investors in bonds, stocks, and property, including housing as mortgage rates declined. But the wealth effect the FOMC hoped for did not spread as planned to the broader economy. Savers were penalized as bank deposit and money market fund returns were decimated, and confidence in vehicles that ordinary Americans depend upon – pension funds, insurance companies and other vehicles used to protect their financial wherewithal in the long term – was undermined. Thus it took longer to restore confidence among consumers than monetary policy makers thought. Especially as fiscal policy and regulatory reform was dead in the water.  With no encouragement from the fiscal and regulatory side, companies used cheaper and more plentiful money to restructure their balance sheets, buy in shares and increase dividend payouts, rather than commit to job creating capital expenditures (CAPEX). Employment, and the consumption that having a job allows, took longer to ramp up than we had hoped.

Accommodative policy is necessary but not sufficient to get the engine of the economy to full function. Money is the fuel for that engine but fiscal and regulatory policy is needed to incent the economy’s drivers – private sector operators – to use that money and step on the accelerator of CAPEX and job creation to get that engine roaring.

The Fed’s policy was followed and intensified in spades by the Bank of Japan and by the European Central Bank.

The Fed curtailed it QE program at the end of October of 2014, then 7 years to the day after we had cut the overnight funds rate to zero, raised it a mere 25 basis points (25/100ths of one-percent) , followed it up with two more moves to snug up to 1%, and is on a declared path to keep nudging it up in 25 basis point increments through year end. When all was said and done, as I stand here today, the FOMC had acquired and now holds $1.74 trillion in mortgage-backed securities and $2.46 trillion in Treasuries, roughly 35% of all U.S. Treasuries outstanding with greater than 5 years’ maturity, in its System Open Market Account (SOMA).

The Bank of Japan, the ECB, and the Bank of England, however, carried on with their programs of radical monetary policy, with the result that after the Brexit vote took place, interest rates hit lows the likes of which have never been seen.

The only reliable long-term records we have on sovereign bonds are maintained by the Dutch. (Holland preceded England and the U.S. as the globe’s financial epicenter). In the immediate aftermath of Brexit, 10-year Dutch sovereigns reached their lowest yield level in 500 years. The Bank of England’s benchmark rate hit its lowest level in 322 years. And the benchmark 10 year U.S. Treasury traded at 1.366%, the lowest rate since Hamilton – not the musical but the real guy, the iconic first Secretary of the Treasury.

And as we all know, there was a plethora of long term issuance in the U.K. and in Europe and in Japan at negative or barely positive interest rates.

Then, as autumn approached, the markets seemed to gag on the low-to-negative interest rate diet prescribed by central banks. Here in the U.S. rates began to rise. By the time of the presidential election, the 10-year Treasury had risen to 1.8%; in Europe negative yields at longer tenors began to evaporate.
The Tug of War Between Rising Rates and the “Orange Swan”

Since the election, rates have risen further. Today the 10-year Treasury is trading at roughly 2.3% and recently traded as high 2.6%. One would have thought that underlying cash flows that support equities and cap rates would have been rediscounted to reflect this move. But that has not yet happened.

I attribute this to the “Orange Swan”. The hope President Trump has engendered of tax reform, deregulation and a more pro-business government has over-ridden what might ordinarily have been a reversal of force in markets outside the fixed income space.

We have seen this before. Between when Ronald Reagan was elected and then inaugurated, the S&P 500 soared 8.5%. But in his first year in office, equities declined 20% as reality set in on the timetable for implementing the changes he promised. It wasn’t until mid-way through his second term in office, for example, that he was able to get tax reform in place.

To be sure, the political dynamics are different today. In his first term, Reagan had to deal with a Democratic majority in the House, where tax reform must be executed. Today, Trump has a sizeable but fractionated Republican majority in the House and a marginal majority in the Senate – but still one where the Vice-president can cast a deciding vote in confirming Ms. DeVos as Education Secretary or the Senate can evoke the “nuclear option” to put Judge Gorsuch on the Supreme Court.

That said, despite the power of the Executive to issue unilateral orders, tax and regulatory reform requires the Congress. Let me show you how Congress really works. [Video: locker room and cell phone]

We may be living in a new world, where Congress has abandoned its spendthrift ways. Still, however pro-business President Trump’s intentions, and even with a Republican Congress that has long been prepared to effect change, major initiatives take time. We will see how long the “Orange Swan” effect holds under the circumstances. And can counter the reality that a more robust economy, should it materialize as hoped, will result in higher interest rates and a Federal Reserve that will have to tighten monetary policy both at the short end and possibly along the yield curve as it deals with the roll over of maturing MBS and Treasuries in its portfolio where $195 billion mature this year, $423 billion mature in 2018, and $430 billion mature in 2019.

How markets will re-discount future cash flows under those circumstances remains uncertain. And then there are these historical precedents: Every Republican president since Ulysses S. Grant has experienced a recession in his first term, including the Gipper.

And since WWII, the Fed has initiated 13 tightening cycles; 10 of those 13 landed the economy in recession.

That ought to make your day!
Remembering Marcus Nadler

Now I don’t want you to leave today thinking I am just one more former central banking sourpuss. I do see the potential for market and political storms. Members of NADSC will have to be alert and stay on the balls of their feet as the landscape in the United States shifts and is tested. But I remind you that Churchill was right: we Americans eventually do the right thing. The U.S. has the capacity to overcome even the greatest of reversals and mishaps and obstacles. We always have and we always will.

I doubt any of you have ever heard of Marcus Nadler. He was a leading thinker at the Federal Reserve during one of our toughest “stress tests”, the Great Depression. With gloom all around and the most thoughtful of people questioning the very survivability of our form of democracy, Nadler put forth four simple propositions:

First, he said, “You are right if you bet that the U.S. economy will continue to expand.”

Second: “You are wrong if you bet that it is going to stand still or collapse.”

Third: “You are wrong if you bet that one element in our society is going to ruin or wreck the country.”

And fourth: “You are right if you bet that (leaders) in business, labor and government are sane, reasonably informed and decent people who can be counted on to find common ground among all their conflicting interests and work out a compromise solution to the big issues that confront them,”

I know Nadler’s third and fourth propositions may seem pie-eyed at present. They were equally outlandish in the 1930’s. And yet we went on from there to become the most prosperous and powerful country in the world.

We might be experiencing political volatility.

We may be poised for a financial markets correction.

But Americans are a unique people. We screw things up pretty badly, pretty often. But we eventually do the right thing. We have no choice now but to do it again.

During the financial crisis, I surveyed the global landscape and described the American economy as the “best looking horse in the glue factory”. Today, I look at the U.S. economy through a different equine lens.  I have another visual of our potential: that of Secretariat at the Belmont stakes in 1973. [Slide of Secretariat wining Belmont] Here he is winning Belmont by an unimaginable 31 lengths, with a heart that weighed 22 pounds, twice the size of any other thoroughbred’s.

That is the American economy.

During the course of my lifetime I have encountered countless naysayers and doomsayers—those that said Europe would lap America, that Japan would lap America, that the so-called BRICS and China would lap America, that we could not compete in a post-Cold War, globalized, cyber-ized world.  To this I say: Horseshift!

We are not the best looking horse in the glue factory. We are Secretariat.

We have the biggest heart.

We can win the race by 31 lengths, if only we can be given freer rein by the fiscal and regulatory authorities.

Just let us out of the stalls.

There’s no country, there’s no people, there’s nobody anywhere on the planet that can outpace us if we are given the freedom to run.

Thank you.

The Other 496 S&P Stocks

So much of the market’s gain this year have been powered by Alphabet, Amazon, Apple and Facebook that strategies that don’t contain those stocks have been left behind

By Justin Lahart

An Apple iPhone displays Facebook’s splash screen. Much of the market’s gains this year have been powered by Apple and Facebook, along with Alphabet and Amazon. Photo: karen bleier/Agence France-Presse/Getty Images        

When one third of the S&P 500’s gain comes from four stocks, there aren’t many ways to beat the market without them.

A good year for the stock market would be a lot less exciting if it hadn’t been for the shares of , AMZN 0.12%▲ Apple, Google parent Alphabet and Facebook . FB 0.45%▲ The combined market value of the four companies has increased by more than $500 billion since the start of the year, making them a major force behind the S&P 500’s $1.7 trillion gain.

They’re also why most S&P sectors have struggled against the overall index.

The total return of the S&P is 10.5% this year. Only three of its 11 sectors have done better: technology (home to Apple, Alphabet and Facebook), consumer discretionary (home to Amazon) and health care.

The S&P 500 Growth index, which holds the S&P 500 stocks with the fastest-growing sales and earnings, and the greatest price momentum, has returned 15.1%. Amazon, Apple, Alphabet and Facebook count for nearly a fifth of its weight. The S&P 500 Value index—the yin to growth’s yang—has underperformed.

Of the four behemoths, only Apple has a dividend, and a rather scant one. No surprise, then, that the S&P High Yield Dividend Aristocrats index, which screens for companies that have consistently increased their dividends, has done poorly. The S&P 500 Equal Weight Index (which puts every stock on an equal footing rather than weighting by market size) has over time tended to outperform the S&P 500. But not this year. Midsize and small company shares, in both the growth and value categories, have also underperformed.

So for almost any investors who adhered to any particular style, 2017 probably hasn’t been so good. And unless they loaded up on the four stocks that happened to power the market higher, it hasn’t been much of a year for stock pickers. The plain-vanilla strategy of just buying the S&P 500 has so far been the right one.

But when the stock market is driven by just a handful of stocks, each of which is substantially more expensive on a price-earnings basis than they were at the start of the year, it can be setting itself up for trouble. It might not take much for investors to suddenly pine for all the stocks and styles they have abandoned.

Rolling up the welcome mat

A crackdown on financial crime means global banks are derisking

Charities and poor migrants are among the hardest hit
WHEN some of Latvia’s banks became infected with dirty money, all paid the price.

“Correspondent” banks—international banks that clear smaller banks’ foreign-currency transactions through big financial centres—began detaching from the Baltic country.

JPMorgan Chase withdrew in 2013. By last year only Deutsche Bank was left. It soon stopped serving half of Latvia’s lenders, and in March began dropping the rest, leaving them at risk of being unable to conduct dollar-denominated transactions, from paying remittances to financing trade.

The exodus happened despite Latvia’s improved financial oversight. In the past two years its regulators put a dozen banks through stringent anti-money-laundering audits. The banks shed 19,000 high-risk clients in the past year alone. As Deutsche continues its phased withdrawal, Latvian banks are trying to persuade it to change its mind, while scrambling to find alternatives. A switch to settling in euros, Latvia’s currency, might be an option, but that poses problems in sectors where goods are priced in dollars, such as commodities.

Strict new rules on capital and liquidity after the financial crisis have tilted the cost-benefit balance away from global banks’ least-profitable clients. But another cause of Latvia’s travails is “derisking”: banks dropping customers in places or sectors deemed to pose a high risk of money-laundering, sanctions evasion or terrorist financing. Though correspondent-banking traffic has continued to rise, banks in small or poor countries are increasingly shut out. The number of correspondent-banking relationships fell in all regions between 2011 and 2016, according to a survey of banks and payments data published on July 4th by the Financial Stability Board, a group of international policymakers (see chart 1). Worst-hit was eastern Europe, which saw a decline of more than 20%. The number in the Caribbean fell by around 10% in 2016 alone. Money-transfer firms and charities have also been hit. Big banks have “unbanked everyone from porn actors to pawnbrokers”, says a regulator.

Banks are driven by fear: fines for aiding financial crime have shot up, in both amount and number (see chart 2). A decade ago banks were paying fines in America, the most punitive country, of tens of millions of dollars a year between them; now they are paying billions. In 2014 France’s BNP Paribas stumped up $8.9bn for violating sanctions on Sudan, Iran and Cuba. Deutsche has been fined several times, including $630m in connection with Russian money-laundering.
In some countries a complete shut-out from correspondent banking looms. The Central African Republic and Nicaragua, as well as Latvia, are down to a single correspondent; in Belize and Liberia even the central banks have lost correspondent-banking services. Some countries, like Belize, brought this upon themselves with lax financial oversight. But others were simply caught in the rush to derisk. The International Monetary Fund says the retreat from correspondent banking has made the global finance system more fragile by concentrating cross-border flows.

The smaller firms that handle remittances are suffering, too. Some 250 had their accounts closed by Barclays in 2013; other banks soon followed. The banks were, in part, reacting to a declaration by the Financial Action Task Force (FATF), an intergovernmental forum that shapes anti-money-laundering policy, that such clients were high-risk. Remittances to developing countries fell in 2015 and 2016 (to $429bn)—the first two-year decrease in three decades—partly because money-transfer firms’ travails made it harder and pricier for migrants to send money home. (Low oil prices, which hit South Asians working in the Middle East, also played a part.)

Dominic Thorncroft of the Association of UK Payment Institutions (AUKPI), which represents money-transfer firms, says 65-70% of its members describe banking as a major challenge. Some have given up their independence and become agents of giants such as Western Union and MoneyGram, for whom international clearing is not a problem. A banker based in the Bahamas says that correspondent banks often tell local institutions: “You can deal with small remittance firms, or you can deal with us, but not both.”

Charities have suffered even more. A recent survey of several hundred by Charity & Security Network (C&SN), a lobby group, found two-thirds had experienced financial problems such as delayed transfers or account closures. Fear of being caught up in funding terrorism has made banks particularly wary of charities active in conflict zones. Though some have indeed been used as fronts by terrorists, “many innocent people are harmed when donations do not get to their intended destination,” says John Byrne of the Association of Certified Anti-Money Laundering Specialists.

Imran Madden, the UK director of Islamic Relief, says the charity had accounts abruptly closed by UBS and HSBC, delaying distribution of life-saving aid. It has found other banks, which have taken the trouble to understand its “painstaking” due diligence, says Mr Madden.

But four years ago it had fewer than 50 transfers queried each year; now hundreds are.

Most charities will speak only on condition of anonymity, fearful that publicity might suggest elevated risk and cause their banks to turn them away. One Syrian-American charity had a transfer to a Turkish vendor blocked by an American bank. It was intended for a hospital in Aleppo; by the time it was approved the city was no longer under siege. An NGO working in Afghanistan says that delays to wire transfers for blankets and other supplies to help a remote village through the harsh winter meant that people froze to death.

Path of least resistance
Concern has grown among the FATF’s members that derisking is actually increasing the risk of financial crime, by boosting cash transactions and the use of informal, unregulated financial networks. More charities are carrying cash: 42% of respondents in the C&SN survey said they were now doing so at least occasionally. A group of 190 American non-profits, InterAction, has started its own network to raise awareness of derisking in Washington.

Banks argue that they are reacting rationally to zero-tolerance regulation. Regulators have imposed a risk-based approach on banks, given them little guidance and then punished them for making some wrong calls, says Jason Sharman of Cambridge University. The IMF has described regulators’ expectations as often “unclear, inconsistently communicated [and] unevenly implemented”.

Until recently, regulators mostly ignored complaints about collateral damage. But they have started to come in for more criticism. Leaving people to die as charities struggle to transfer money does not play well. And the governments that want to clean up financial flows also want to boost poor countries’ development. That requires international banking services, both for firms and for people. For many countries, remittances from their migrant workers dwarf international aid.

So regulators are trying to improve their guidance. The FATF, for instance, has said that correspondent banks need not “KYCC” (know your customer’s customer)—that is, look through their client banks to scrutinise those banks’ account-holders. It has toned down sweeping assertions about charities and money-transfer firms being particularly likely to be involved in financing terrorism. The IMF is working with regulators in the most severely affected countries to improve their financial oversight. Big banks are starting to chip in.

Standard Chartered, for example, runs correspondent-banking “academies”, sharing expertise in due diligence; the most recent, in Dubai, was for Middle Eastern banks.

Some of the countries affected are responding creatively. Mexico, long plagued by drug-money-laundering, is working out how to make payments easier to trace. A domestic dollar-payments system requires payment messages to include an IP address and biometric data from a legal representative of the sender. Similar identifiers are used for cross-border transactions, allowing regulators to spot suspicious patterns. These go into a database to which banks must refer when doing risk assessments. This has reassured some foreign correspondent banks, says Miguel Diaz, the head of payments at Mexico’s central bank. “We knew we had a particular problem here and had to go the extra mile.”

Better, cheaper compliance should allow banks to take back some of the clients who were ditched because they were not profitable enough to outweigh the risk, says Vijaya Ramachandran of the Centre for Global Development, a think-tank. About 3,700 of the banks that are members of SWIFT now use the payment-messaging system’s data registry to collect required information about the banks for which they act as correspondents, thus cutting compliance costs. Takis Georgakopoulos of JPMorgan Chase, the largest clearer of dollar transactions, holds out hope for the blockchain technology behind bitcoin, a digital currency.

This encodes a record of valid transactions with time stamps, which can be a cheap, easy way to verify customers.

At a recent conference for American bankers, only one in ten said they expected to reduce the number of correspondent-banking partners in the next year. In contrast, an earlier straw poll of European banks suggested more than half thought they would. This may suggest that American banks, which were first to derisk, will also be first to ease off.

Emile van der Does de Willebois of the World Bank says that big banks seem a bit more willing than a couple of years ago to service small banks in places like the Caribbean and Africa—albeit often indirectly, through mid-sized regional banks in “nesting” arrangements.

As for money-transfer firms, Mr Thorncroft at the AUKPI cites two potential improvements: proposals to require banks to give their reason for rejecting a client, and the rise of new “challenger” banks in Britain, which seem keen to woo his members.

Paralysed by fear
But these are only tentative signs. Anti-money-laundering compliance costs remain high: $60m a year for the average bank and many times that for the largest. And the screening products used by banks are still far from perfect: in February, for instance, the Finsbury Park mosque in London won an apology and damages from Thomson Reuters after being wrongly placed in a terrorism-linked category on a database compiled by the financial-information firm. That had made banks wary of serving the mosque.

Most banks still worry that if they dare to “re-risk”, it could lead to a fresh round of hefty fines.

Charities remain pessimistic, too, despite talk of creating government-endorsed lists of vetted humanitarian-relief groups that banks could safely serve. “Banks are responding to a regulatory crackdown,” says Tom Keatinge, a former banker now with the Royal United Services Institute, a think-tank. “Regulators worry about the strength of that response but don’t want to micromanage risk. Both are acting rationally, but combined they create a problem that looks intractable.”

Chinese Finance Meeting’s Meager Results Reflect Nation’s Problems


Speaking at China’s National Financial Work Conference, President Xi Jinping acknowledged the financial system’s importance to the country. Credit John Macdougall/Agence France-Presse — Getty Images        

SHANGHAI — China’s top leaders have gathered every five years since 1997 for a National Financial Work Conference. At past gatherings, they have created entire regulatory agencies and rearranged the rules for huge markets, almost overnight.

So economists and regulators have been almost breathlessly speculating about this summer’s work conference. Would the regulatory commissions overseeing the banking, securities and insurance industries be merged into the central bank? Would the legal definition of securities be broadened to shed some regulatory daylight on widespread activities like shadow banking, peer-to-peer online investment networks and off-balance-sheet wealth management products?

But the actual results of the two-day work conference, which ended on Saturday afternoon, were much more, well, modest, to put it politely.

The biggest accomplishment of the conference appeared to be an announcement that a commission would be established under the auspices of the cabinet. The commission would meet regularly to discuss issues of financial stability.

But the leaders of the various financial regulatory agencies already meet regularly at the offices of the State Council, which is China’s cabinet, although these meetings are not officially at the level of a commission.

Some economists speculated in the final days before the two-day conference that at least the State Council meetings would be moved to the central bank. Allowing the central bank to serve tea and provide a conference room might give the central bank staff a little extra confidence by allowing them to negotiate as hosts. The central bank also has a history of advocating broader financial reforms than the other principal financial regulatory agencies: the China Banking Regulatory Commission, the China Securities Regulatory Commission and the China Insurance Regulatory Commission.

But the leaders did not even move the meetings away from the State Council’s offices to the central bank. And the result of the conference fell far short of predictions that the regulatory agencies might become clearly subservient to the central bank.

The statement that accompanied the end of the conference did mention that the central bank had a role to play in preventing systemic financial risk. That is already the role of central banks in many countries. But Gary Liu, the president of the China Financial Reform Institute, a research group based in Shanghai, said that the specific mention of it in the statement might strengthen the central bank’s hand somewhat.

But he was skeptical of the new commission, noting that it would lack legal powers and have very few staff members. “China failed to achieve a real breakthrough in financial regulatory reform, and the rising conflicts between financial regulation and financial realities will continue to create troubles in the coming years,” Mr. Liu said.

Overall debt has been soaring in China, and Moody’s Investors Service downgraded China’s sovereign debt rating by a notch on May 24 on concerns that China has struggled to contain further increases in that debt. Chinese officials are quick to acknowledge the importance of financial health to the Chinese economy, which has become the world’s second-largest economy after the United States’, with extensive links to practically every other country around the world.

State-controlled media carried a statement that described President Xi Jinping of China as having said at the conference, “Finance is an important core competitiveness of the country, financial security is an important part of national security, and the financial system is an important economic and social development of the basic system.”

The apparently meager results from the conference underline not just bureaucratic resistance to change, which Mr. Xi probably has the political muscle to overcome, but the very real and complex policy dilemmas facing China.

One example lies in the vast, lightly regulated off-balance-sheet activities of Chinese banks, which Mizuho Securities calculated on Friday to be roughly equal to the entire assets on the balance sheets of the banking industry. Regulators in the West would probably force banks to move these activities as quickly as possible onto their balance sheets, which would probably have the effect of curtailing them.

But many of these off-balance-sheet activities, like various kinds of loan guarantees, are crucial to providing financing for China’s vigorous small and medium-size enterprises. These smaller businesses have had little luck competing with large, state-owned enterprises for conventional bank loans. But they account for the bulk of the job creation in China, at a time when the government is trying to slim down chronically loss-making industries like steel manufacturing and coal mining that are also big employers.

Other financial regulatory disputes in China involve bureaucratic turf issues. One question lies in how to modernize China’s antiquated securities law, which still applies only to stocks and bonds and lacks provisions to cover the more complex instruments issued these days by insurance companies, banks, online lenders and other types of financial institutions.

The China Securities Regulatory Commission has pushed hard for the broadest possible definition of securities, which would give it much greater influence. The banking and insurance regulators have resisted this, contending that many of the new financial instruments are extensions of banking and insurance.

One mystery left unresolved by the statement at the end of the conference lies in who will run the top financial regulatory agencies in the years ahead, particularly the central bank.

Zhou Xiaochuan has been the governor of the central bank, the People’s Bank of China, since 2002, making him one of the world’s longest-serving central bankers. Mr. Zhou is already more than two years past the usual retirement age for Chinese officials at his level. He received a special dispensation from the usual age limits by being allowed to join a senior government advisory body that is exempt from age limits.

Central banking specialists in China cite two likely front-runners to succeed him. One is Jiang Chaoliang, the Communist Party secretary of Hubei province and a former chairman of the Agricultural Bank of China. The other is Guo Shuqing, a former governor of Shandong province who in February became the chairman of the China Banking Regulatory Commission.

Game Theories

Any coach or philosopher will tell you that the rules of sport mirror those of life (and vice versa). Michael Shermer reviews ‘Knowing the Score’ by David Papineau.

By Michael Shermer

     A breakaway on July 2 during the Tour de France. Photo: Agence France-Presse/Getty Images

Among cycling aficionados, Peter Yates’s 1979 film “Breaking Away” was a welcome vehicle to convey the elegance of the sport to a largely oblivious American audience. Like most sports films, it was also something more: the story of a man struggling to break away from the provincialism of family and friends, along with a morality tale about how everyone lies a little and some people cheat a lot.

In “Knowing the Score,” King’s College philosopher David Papineau uses bike racing and other sports as metaphors for lessons about the most important issues in philosophy and life.

He confesses his ignorance of cycling and admits that he did not understand, when watching the 2012 Olympic road race, why four women cyclists from different countries would work together after they broke away from the peloton. Mr. Papineau finds an answer in game theory, the analysis of competition and cooperation between rational actors in a conflict situation. Cyclists drafting one another create a significant savings in energy and an increase in speed, so solo breakaways are unusual and almost always fail.

Drafting in the middle of the pack for the entire race is very efficient, but then you have to sprint for the win against the entire field. Ideal is a small breakaway with, say, four riders: Each can conserve energy and only has to beat three others to win. In game-theory terms, it pays for each of the four racers to cooperate with one another until the very end. If one rider “defects” (in game-theory terms) and refuses to take a pull at the front, the others will punish her, verbally or by other means.

Occasionally, in the final kilometer, everyone in the breakaway refuses to pull through in order to conserve energy for the sprint, and the group gets caught by the hard-charging peloton, an example of selfishness surmounting selflessness to the detriment of all. On the other hand, knowing that this can happen discourages early defection and keeps the provisional mutualism going.

Each chapter in Mr. Papineau’s engaging book takes a look at a philosophical problem like this, presented by a sport, and links it to phenomena in the wider world. The author finds cyclists’ conflicts between self-interest and group interest to be mirrored in relations between nations:

Agreements attempting to combat climate change, for instance, face a collective-action problem that must contend with “breakaway” nations that desire greater economic growth. In other sections, failure to meet political obligations in a society is equated to fouls in an athletic contest; sporting competition among nations is connected to geopolitical rivalry ( George Orwell once commented that sport “is war minus the shooting”); nature and nurture are discussed in terms of athletic performance and life (gifted athletes have gifted children, but not equally so). Mr. Papineau also applies economic concepts, like Coase’s theorem—stating that free markets with well-defined rules lead to relative efficiency—to sports, in which the best players migrate to the best teams and earn the most money unless an artificial mechanism like a draft is devised so as to level the playing field.

Another lesson that Mr. Papineau’s book imparts is that athletic contests are not just another form of play. Most people want more than just a happy existence. We want challenges to face and obstacles to overcome. Our ancestors got more of those from daily life than we do today, so we need artificial trials. Sports are, in that sense, the very embodiment of the human striving that brings meaning to life.