Thoughts on Liquidity

Doug Nolan

“Money” challenged - and often confounded - economic thinkers for centuries. It functions both as a “medium of exchange” and “unit of account.” Simple enough. Too often the focus has been how to use money to stimulate economic activity and achieve political gains. From my perspective, money’s importance lies with its fundamental roles as a “Store of Value” and the bedrock of financial systems. Unsound money has been a root cause of a lot of turmoil throughout history – including the monetary fiasco that collapsed in 2008. Yet concerns for the soundness of contemporary “money” these days are viewed as hopelessly archaic.

My thinking on contemporary “money” has been adapted from a much earlier focus on money’s “preciousness.” Traditionally, money was precious either because it was made of or backed by gold/precious metals. It retained preciousness only so long as its quantity remained carefully contained. Throughout history, the value of “paper money” has invariably moved inversely to the quantity issued – fits and starts, enthusiasm and revulsion and, too often, a path to worthlessness.

Today, “money” is largely electronic/digitized IOUs/Credit – but a special kind of Credit. Money is a perceived safe and liquid store of (nominal) value. This perception assures essentially insatiable demand. Unlimited demand creates a powerful propensity for over-issuance. Historically, monetary inflation ensured the Scourge of Inflationism. Monetary excess distorted flows to goods markets, setting in motion problematic inflationary dynamics in incomes, spending patterns and economic structure.

Despite money’s critical role within an economy, a consensus view on how best to define, monitor and manage the “money supply” escaped both the economics community and policymakers more generally. Too often, politics and ideology muddied already murky analytical waters. What is money these days, and how best to manage monetary matters? Does anyone even care – so long as the securities markets are strong?

If issues surrounding “money” aren’t confusing enough, how about this thing we refer to as “Liquidity.” As we wrap up a wild year in global markets, it would be fitting to label 2018 “The Year of Liquidity.” The year began with a bang, as liquidity inundated the emerging markets. It’s easy to forget that the Shanghai Composite jumped 5.3% in January. Brazil’s Ibovespa surged 11.1% in January and was up almost 15% by late February. The emerging market ETF (EEM) had jumped 10.5% by January 26th. South Korea’s KOSPI index rose 4.0% in January, and India’s Sensex gained almost 6%.

One could reasonably assert that “Liquidity” was in great abundance – in EM and global markets well into 2018. “Money” was flowing readily into the emerging markets, although it would be more accurate to state “finance” was flowing. Speculative Credit was most certainly expanding rapidly, as “carry trades” and a multitude of derivatives strategies funneled newly generated purchasing power into “developing” markets and economies. To be sure, the perception of a world awash in “Liquidity” ensured a problematic buildup of speculative leverage.

In general, free-flowing Credit is inherently self-reinforcing and validating (ongoing expansion supporting the perceived creditworthiness of the existing Credit structure) – hence unstable. Credit for securities speculation – speculative leveraging – is acutely unstable. The expansion of speculative Credit creates a flow of buying power, or Liquidity, that inflates securities prices and engenders only greater demand for speculative Credit. Resulting Liquidity abundance fosters confidence that markets will continue to boom skyward. “Money” everywhere.

The expansion of GSE Credit was key to the perception of Liquidity abundance early in the mortgage finance Bubble period. The expansion of GSE liabilities generated a powerful flow of buying power/Liquidity into the marketplace. Moreover, the ability and willingness to aggressively expand GSE Credit in the event of heightened market stress fostered the perception that a governmental quasi-central bank entity was available to backstop system liquidity when needed. By late in the cycle, a booming Credit expansion was creating such a prodigious flow of Liquidity that markets had little concern that fraud at the GSEs essentially eliminated their capacity to backstop market Liquidity.

Simplifying the analysis, we can consider four key – and interrelated - elements to market “Liquidity.” First, the actual purchasing power (i.e. deposits, money market funds, etc.) available to purchase securities. Second, the ease of availability of speculative Credit for the leveraging of securities. Third, the willingness and capacity of market-makers and operators to accumulate holdings in the face of intense selling pressure. And, fourth, the perception of Liquidity flows that could be injected into the system in the event of market instability and illiquidity risk (GSE backstop bid during the mortgage finance Bubble - and central bank QE throughout the global government finance Bubble).

M1 money supply ended last week at $3.736 TN, with M2 at $14.415 TN. M2 is a rather straightforward calculation adding Currency, Deposits (checking/saving/small time/other) and Retail Money Market Funds. The Federal Reserve in the past calculated M3, a broader measure of money (adding large time deposits, institutional money funds and repurchase agreements). Long arguing that broad “money” was analytically superior to the narrow aggregates, I nonetheless lost no sleep when the Fed discontinued publishing its M3 aggregate (still too narrow!). Our analytical frameworks should strive to incorporate the broadest view of “money,” Credit and “finance,” although the broader the view taken the more challenging the analysis.

I would posit that some time ago Liquidity completely supplanted the monetary aggregates as the key focal point of market flow analysis. Unfortunately, there is no quantity of “Liquidity” to measure and tabulate. I am not familiar with an adequate definition or even common understanding. The concept of contemporary “money” has proved highly problematic for the economics community. Yet Liquidity makes “money” appear quite straightforward. If it can’t be defined or calculated, it’s certainly not worthy of inclusion in econometric models.

Liquidity is an amalgam of real financial flows and intangible market perceptions. There is no aggregate that would signal whether Liquidity is either expanding or contracting. Even if overall Liquidity was viewed as either abundant or deficient, there would still be widely divergent Liquidity manifestations for individual sectors, markets, countries or regions. And how can seeming Liquidity overabundance so briskly transform into illiquidity?

“Money supply” was an invaluable tool for gauging system “Liquidity” back when bank liabilities (i.e. deposits) were the prevailing mechanism for money and Credit expansion. Analysis has changed profoundly with the globalized adoption of non-bank market-based Credit. I have argued that market-based Credit is highly unstable – speculative Credit perilously so. I would contend that “Liquidity” is typically steady but at times highly erratic. So long as the global Credit boom continues, speculative Credit expands, and markets remain stable, the perception of Liquidity abundance ensures ample purchasing power to sustain the bull market. But the Wildness Lies in Wait.

For years now, global central bank policies have been fundamental to the perception of uninterrupted Liquidity abundance. Chairman Bernanke’s zero rates and QE measures caused a historic flow of purchasing power (Liquidity) into stock and fixed-income funds. This evolved into a momentous shift of financial flows into “passive” risk market strategies (perceived as low-risk and, often, money-like). Ultra-low rates and the belief that central banks were backstopping market Liquidity fundamentally altered both the flow of Liquidity and, over time, the structure of the marketplace.

The flow of Trillions into ETF and other “passive” strategies changed the nature of global leveraged speculation. Not only were the leveraged speculators incentivized by near zero (and even negative) borrowing costs and confidence in the central bank Liquidity backstop, they were now emboldened by the predictability of huge “retail” flows into stock (domestic and international) and fixed-income funds. Booming flows into equities and bonds fundamentally loosened financial conditions on an unprecedented global basis.

Loose finance stoked asset inflation, booming M&A and buybacks, all conducive to economic expansion and surging corporate profits. Liquidity circulating briskly throughout both the Financial and Economic Spheres bolstered the perception of an endless Liquidity boom. Booming securities markets fueled U.S. consumption and ongoing huge trade deficits, dollar Liquidity flowing out to the world - only to be recycled right back into U.S. securities and asset markets (i.e. EM central bank purchases, hedge funds borrowing in offshore markets to leverage in U.S. securities, Chinese buying U.S. Treasuries and real estate, etc.). Meanwhile, booming global markets and the ease of “investing” passively through the ETF complex stoked unprecedented U.S. flows to global markets – once again generating a flow of global Liquidity that would be readily “recycled” back into U.S. markets.

Early CBBs introduced the concept of the “infinite multiplier effect.” Contemporary finance (largely devoid of capital and reserve requirements) left the old fractional reserve banking deposit “money multiplier” in the dust. The flow of purchasing power/Liquidity would circulate and recirculate, in the process fueling both unfettered Credit expansion and asset inflation. The global government finance Bubble period – with its zero rates, Trillions of new “money,” and central bank liquidity backstops – has seen the “infinite multiplier” at work on an unprecedented global scale. Liquidity created by the central banks, as well as through massive government debt expansion and leveraged speculation, has circulated freely on a global basis, inflating securities/asset prices, stoking economic expansion and promoting a self-reinforcing perception of endless Liquidity.

For the most part, contemporary market Liquidity is not real. It’s primarily a market perception. It’s based on the view that financial flows into markets will remain positive and, on those rare occasions when they’re not, central banks will step in and ensure “money” flows unabated into the financial markets. It’s based on confidence and faith - in contemporary central banking, in market structure, in the derivatives complex, in modern technologies and ingenuity. It’s based on the view that global Credit will continue to expand, premised on confidence that Beijing will ensure ongoing Credit expansion and that U.S. Credit is fundamentally robust. It’s based on the overarching belief that global finance is fundamentally sound, policymakers possess acumen and enlightenment, central bank power is boundless, and the global economy is on solid footing.

I believe the February blow-up of “short vol” strategies was a key initial crack in the global Bubble. Huge speculative excess had accumulated in a major market used for acquiring protection against market declines – writing “flood insurance” during a protracted central bank-induced drought. Abrupt market losses and illiquidity changed the risk/reward calculus for “selling” market “insurance” – reducing the supply and increasing the price of protection. Not long after, indications of fledgling risk aversion began to beset the global “Periphery.” EM Liquidity began to wane, an especially problematic dynamic following a speculative blow-off period. As EM flows reversed, de-risking/deleveraging dynamics took hold. Liquidity that seemed so abundant early in the year suddenly disappeared, replaced by faltering markets, dislocation and fear of expanding market illiquidity throughout the “Periphery.”

On a global basis, the Liquidity backdrop had changed momentously. For the first time in several years, a significant de-risking/deleveraging dynamic was unfolding without the benefit of huge central bank QE liquidity injections. Rapid currency collapses in Turkey and Argentina signaled a critical global Liquidity inflection point. And as de-risking/deleveraging gained momentum, Contagion became a major concern. China and Asia, the epicenter of Liquidity excesses over this cycle, saw their currencies, equities and bonds fall under significant pressure. Dollar-denominated debt, having so flourished during Liquidity abundance, was suddenly facing sinking prices and Liquidity issues. The shifting Liquidity backdrop was also manifesting in the colossal international derivatives markets (i.e. currency, swaps and fixed-income).

Market perceptions with regard to international Liquidity changed meaningfully. The same could not be said for the U.S. If anything, expectations for ongoing Liquidity abundance became only more deeply ingrained. Keep in mind that the Federal Reserve concluded QE operations in 2014. With the bull market having not missed a beat, it was widely believed that QE was irrelevant for the U.S. Not appreciated was the major role QE was having on international Liquidity, with “money” created by the ECB, BOJ and others finding its way into U.S. securities markets and the American economy. This year’s instability at the “Periphery” then initially exacerbated flows to “Core” U.S. markets, pushing already highly speculative markets into Melt-Up Dynamics.

From a Liquidity perspective, speculative blow-offs are highly problematic. A bout of manic buying and leveraging culminates in highly elevated and unsustainable prices and financial flows. The perception of Liquidity abundance sows the seeds of its own destruction. When prices inevitably reverse, the onset of de-risking/deleveraging dynamics ensures a highly problematic Liquidity environment.

When the Crowd is fully on board, who is left to buy? When the leveraged speculating community reverses course, who but central banks have the capacity to accommodate deleveraging? If a significant segment of the marketplace moves to hedge market risk, where is the wherewithal to shoulder such risk? And let’s not overlook the critical issue of market risk shifting to speculators and traders expecting to dynamically-hedge option risk written/sold in the marketplace (planning, when necessary, to establish short positions in a declining marketplace). Current Market Structure ensures serious Liquidity issues upon the inevitable bursting of speculative Bubbles. Who wants to get in front of the algos?

Progressively more reckless central bank measures over the past decade have been necessary to promote the perception of ample and sustainable Liquidity. But with Crisis Dynamics having recently afflicted the “Core,” it is difficult for me not to see a Liquidity environment fundamentally altered. Confidence has taken a significant hit. I believe the leveraged speculating community has been impaired, with outflows and general risk aversion ensuring ongoing de-risking/deleveraging. Similarly, with confidence in “passive” (stock, fixed-income, international) ETF strategies now badly shaken, it is difficult to envisage a return to booming industry inflows. And with derivatives players stung by abrupt market losses and a spike in volatility (option premiums), I expect we’ve passed a critical inflection point in the pricing and availability of market protection.

The backdrop points to an inhospitable Liquidity backdrop. Serious market structural issues have bubbled to the surface, issues market participants either haven’t appreciated or simply believed would readily rectify by central banks before confidence was impacted. The orientation of powerful financial flows has been upset. Hedging and derivatives markets have dislocated. The great fallacy of “moneyness” for risky stocks, bonds and derivatives is being laid bare.

Importantly, I view speculative Credit as the marginal source of global Liquidity. I believe a historic Bubble in securities and derivatives-related Credit has been pierced. This Bubble was fueled by years of zero/negative rates and Trillions of central bank liquidity. As we saw this week, bear market rallies tend to be ferocious. And when a short squeeze and unwind of hedges is in play, surging prices will spur hope the sell-off has run its course and that Liquidity has returned to the markets.

It’s just not going to be that simple. Global markets face serious structural issues years and decades in the making. Hopefully markets can avoid crashes and make necessary adjustments over an extended period of time. For a while now, I’ve feared a scenario where illiquidity becomes a systemic global issue. From closely analyzing previous booms and bust episodes, things often prove even worse than I suspect.

Investors must realise that 2018 was no aberration

The level of uncertainty facing investors in the new year is particularly acute

Nikhil Srinivasan

© FT montage; Bloomberg

Being wrong does not appear to be a restraint for those making market predictions. The S&P 500 is down 7.7 per cent for the year while the 10-year US Treasury yield isn’t that far from where it began the year. That is quite the opposite of what was being forecast.

This won’t temper the soothsayers, so let me add my two cents worth. I admit to being uncertain about the near term and so prefer to rely on the facts at hand. The facts suggest one should maintain a short duration on assets across the board.

First, there is no inflation anywhere that matters. Wage increases haven’t turned into runaway inflation in the US, Chinese inflation is subdued and European inflation expectations keep being revised lower.

Second, China’s economic growth is very slow. Irrespective of whether Beijing strikes a trade deal with Washington and some reasonable fiscal measures (eg tax cuts) are introduced, the world’s second-largest economy is slowing. Just look at auto, construction machinery and home sales — not to mention household debt levels that have tripled in less than a decade.

There should be a strong attempt from Beijing to reflate the economy and weaken the currency. It’s the right thing to do but will have consequences for asset prices globally.

Third, the US can fund its fiscal deficit. There have been plenty of market calls on the trillion dollar-plus deficit forecast for 2019 and the need for higher yields to ensure funding. So far, the calls have been, well, wrong. The 2018 deficit should come in at about $800bn with the 10-year bond yielding about 2.75 per cent. Go figure. The dollar is the world’s reserve currency with no competition for the moment.

Fourth, volatility in markets is not just a creation of American policy. Don’t forget Europe — weak banks, poor politics and an abject mishandling of the UK and Italian situations. The continent isn’t likely to be a winner from any currency adjustment in China.

Fifth, emerging market equities are not a no-brainer. EMs have been attracting significant inflows this quarter. Yes, EM is cheaper on traditional price to earnings measures — maybe 11 times forward earnings versus 15 times for developed markets. But I am sceptical on earnings growth in 2019. Can EM outperform DM? Yes. Can EM deliver a substantial absolute positive return? Not without less volatility in DM and some clarity on Chinese economic policy. China is the anchor.

Anchors need to be stable. It’s an uncertain world. What should one consider doing? Calibrate duration risk — if one is uncertain about the future, one should be thoughtful about taking duration risk on any asset. Money market funds are yielding 2.5 per cent, now an asset class of its own again.

The government bond yield curve is flat. So, why extend duration? Short term credit yields are also up.

What about private equity? Deals are pricing north of 11 times Ebitda versus 9 times in 2013. The leverage loan market has been under pressure this quarter, leaving banks stuck with loans they can’t syndicate and leveraged loan ETFs and funds are seeing redemptions. Financing is becoming more expensive. You should think hard before committing funds for 20 years at this point.

Venture capital valuations are very extended relative to 2003 and 2008 as well.

Private Credit has been a great story for the best part of the decade. Quantitative easing was its rocket fuel. But I would prefer credit special situations strategies at this point for instance, focused on dislocations in the corporate bond market that are bound to occur.

If you want exposure to equities, stay passive. You may know the odd good active manager, but otherwise passive is best. Such funds have faced much opprobrium, but why lean back towards active management where there is no assurance of outperformance.

On the commodities front, I would recommend owning some precious metals. If there is deflation in asset prices, such securities will outperform.

On the macro front, watch for two things. As mentioned, there is a potential currency adjustment from China, which would be negative for asset prices. I would, however, be long Chinese stocks in anticipation and thereafter.

The other is the Fed possibly slowing its tightening of monetary policy. With $11tn of dollar debt outstanding outside the US, any move that improves dollar liquidity will be bullish for risk assets.

I would be less focused on reading the tea leaves on the next move on interest rates, and more on the possibility of the Fed slowing its quantitative tightening that is running at $50 billion monthly.

This is not a time for a market investor to think long term. There are too many unknowns. The retort will be you can’t time the market. Perhaps, but you can recognise uncertainty and you can be patient.

We all want the bad times to be short and good times to be extended. But don’t expect 2018 to be an aberration. The good times are on hold until further notice.

Nikhil Srinivasan is CIO of Partner Re

GLD: Did Santa Come Early This Year?

by: Income Generator

- Turmoil in stock markets continues, and investors are looking for ways to protect their portfolio holdings.
- Equities have officially fallen into bear market territory, as the S&P 500 is trading lower by -12.06% and the Dow Jones Industrial Average has lost -11.84% on a YTD basis.
- The resulting uncertainty has driven investors back toward the SPDR Gold Trust ETF as a classic safe haven beneficiary.
- Long-term trends in behavioral economics may be changing, and GLD is already trading at its highest levels in roughly six months.
- Ultimately, this suggests that GLD rests on strong footing within the market as we begin 2019.

As the massive sell-off in stocks continues, investors are seeking the protection of the market’s classic safe haven assets. On a year-to-date basis, the S&P 500 is trading lower by -12.06% and the Dow Jones Industrial Average has lost -11.84%. Equities have officially fallen into bear market territory and this has significantly darkened the outlook for 2019. Earlier this year, the SPDR Gold Trust ETF (GLD) had been written-off by a large majority within the analyst community. As bullish stock investors clearly held the advantage, valuations in GLD dropped to multi-year lows and many investors were beginning to question its strength and validity as a true safe haven instrument. But now that the tide has turned in equities, those assessments have been proven to be incorrect. GLD is now trading near its highest levels in six months, and these bullish trends look set to move higher as long as widespread uncertainty continues to grip the financial markets.
For most of the year, valuation levels in the SPDR Gold Trust ETF were almost exclusively focused on the downside. This bearish activity occurred even as the market experienced many of the “flash crash” events which were present during the early parts of this year. Selling pressure in GLD continued until mid-August, when the ETF hit its annual lows at 111.10. Since then, however, the SPDR Gold Trust ETF has reversed strongly and generated outperforming gains of 8.03%.
Deteriorating growth figures in emerging markets and new possibilities of a prolonged government shutdown in the United States have added to the weaknesses in equities which were already present.
The resulting uncertainty has driven investors back toward the SPDR Gold Trust ETF as a classic safe haven beneficiary.
(Source: Author)
Moreover, that safe haven status seem to be ready to outperform other protective instruments (for example, the U.S. dollar). When viewed in terms of the EUR/USD currency pair, the greenback has started showing losses and this gives us evidence that the prior bullish trend in the currency may be ready for reversal. Precious metals assets are largely priced in U.S. dollars, and a declining value in the currency can make gold assets cheaper for global investors.
In these December trends continue, it should provide some supportive lift for GLD heading into 2019.
(Source: Author)
Trend reversals in the U.S. dollar index have also become apparent relative to the Japanese yen, which has gained 3.68% since the USD/JPY hit its highs in early October. The Federal Reserve has altered its monetary policy stances in recent meetings, and it looks to be relatively certain that the U.S. currency will not benefit from three or four rate hikes in 2019 (as previously thought). The Trump tax cuts are already priced into market valuations in equities, and the deteriorating growth environment could weigh on the U.S. dollar in the quarters ahead.
(Source: Bloomberg)
The market seems to agree with this stance, as investors have actually broken from the historical trends found in behavioral economics. In most cases, the underlying price of gold does not rally before the Federal Reserve raises interest rates. This is because gold is a non-yielding asset, and this characterization is also valid for those holding long positions in the SPDR Gold Trust ETF. Interestingly, precious metals have actually moved higher into the most recent Fed rate hike. This indicates growing divergences in investor expectations with respect to the ways precious metals instruments will travel in the quarters ahead.
Long-term, the fund flows which have been directed toward GLD offer a primary indicator of the market’s demand for safe haven assets. As stocks rallied over the last year, the SPDR Gold Trust ETF was negatively impacted by outflows of $2,492.2 million. This negative trend held up in a consistent manner, with outflows of $2,112.6 million over the last 26 weeks.
Those trends appear to have reversed, however, during more recent trading periods. Over the last 13 weeks, GLD has benefitted from inflows of $1,083.7 million. This actually puts the fund near the highs for the category, and this bullish reversal has continued over the last week and the last month of trading. Ultimately, this suggests that the SPDR Gold Trust ETF rests on strong footing within the market as we begin 2019.
(Source: U.S. Global Investors/Metals Focus)
Even longer-term, those same trends appear to have the fodder needed to build on recent rallies. Gold consumption forecasts through 2023 suggests that growing demand levels will continue. Large portions of this growth in demand are expected to come from jewelry production and industrial uses.
But what is most striking about these trend expectations in the rise in net physical investment which is anticipated to occur over the next half-decade. If these forecasts come true, it would mark a significant trend shift in the ways investors view GLD and other precious metals instruments within the broader market.
(Source: Author)
Of course, many GLD bears will likely argue that recent moves have done little to change the broader price trends in the SPDR Gold Trust ETF. In many ways, this is a fair criticism because GLD has retraced less than 50% of the peak-to-trough losses which have been generated this year. But precious metals investors are increasingly viewing GLD as a preferred diversifier which protects against volatility in equities and systemic risks in the global economy.
As the massive sell-off in stocks continues, investors are seeking the protection of the market’s classic safe haven assets and GLD may continue to be a primary beneficiary of these trends. In most cases, the month of December is the “most wonderful time of year” for stocks.
Unfortunately for many, the Santa Claus rally seems to be rewarding precious metals investors rather than those with exposure to the S&P 500, NASDAQ, and Dow Jones Industrials. The SPDR Gold Trust ETF is now trading at its highest levels in six months and many investors are asking one key question: Will these trends continue in 2019? A short-term answer to this question might still be premature.
But what is clear is that GLD has placed itself on a firm footing to outperform in 2019.

Markets Aren’t Helping Deutsche Bank Shake Off Bad News

Investment banking is getting more difficult, just as the German lender needs support

By Paul J. Davies

It was a shock when Deutsche Bank ’s DB -6.50%▲ stock closed at a then-record low of €9.16 in late May. Chief Executive Christian Sewing wrote to staff: “There’s no reason for us to be discouraged. Yes, our share price is at a historic low. But we’ll prove that we have earned a better valuation on the financial markets.”

Now, the troubled German lender is limping to the end of a very hard 2018 with its shares closer to €7.00. With a shaky outlook for markets and a seemingly inescapable flow of bad news, it isn’t easy to be sure things won’t get worse.

If they do, German politicians are hovering nervously in the background and might intervene, most likely by pushing Deutsche into a local marriage with Commerzbankthat would probably be dilutive for shareholders.

There will be some good news in February. Deutsche should report its first full-year profit since 2014. This is down to Mr. Sewing achieving the one thing he was absolutely determined to achieve: his cost target.

But the bank has kept losing revenue and the fourth-quarter flow of bad news won’t have helped. Deutsche has had internal management battles publicly exposed, been raided by investigators in a global tax-evasion probe, been linked to the money-laundering scandal at Denmark’s Danske Bankand—to cap the year—been placed at the center of a European investigation into the manipulation of government-bond markets.

The latest blow could be slight: Deutsche said it expects no financial penalty from the bond probe, although it could theoretically be fined up to 10% of annual global revenue. But none of these events inspires confidence among clients, investors or staff.

Deutsche Bank CEO Christian Sewing at the Frankfurt European Banking Congress in Germany on Nov. 16.
Deutsche Bank CEO Christian Sewing at the Frankfurt European Banking Congress in Germany on Nov. 16. Photo: armando babani/epa-efe/rex/Shutterstock

More concerning is generally weak investment-banking activity: JPMorganand Citigroupboth warned in early December that fourth-quarter revenue would likely be down about 25% versus the third quarter. Deutsche has been losing market share to global rivals all year, so such warnings are ominous.

Deutsche’s stock price fall has been precipitous—down almost 60% this year—but its valuation as a multiple of forecast book value suggests cold logic, not hot panic. A price-to-book multiple of 0.24 times is justified by a return on equity of just 2.5% next year, as brokerage Berenberg estimates.

Deutsche Bank needs time to restore trust among clients and regulators, to find a surer footing for its strategy and revenue, and thus to lower funding costs and lift profitability. But it doesn’t just need time, it needs fair winds in market activity and—for once—no more bad news. 2019 holds no promises.

In Defense of the Fed

Despite howls of protest from market participants and rumored threats from an unhinged US president, the Federal Reserve should be congratulated for its commitment to normalizing interest rates. There is simply no other way to break the US economy's 20-year dependence on asset bubbles.

Stephen S. Roach

jerome powell fed

NEW HAVEN – I have not been a fan of the policies of the US Federal Reserve for many years. Despite great personal fondness for my first employer, and appreciation of all that working there gave me in terms of professional training and intellectual stimulation, the Fed had lost its way. From bubble to bubble, from crisis to crisis, there were increasingly compelling reasons to question the Fed’s stewardship of the US economy.

That now appears to be changing. Notwithstanding howls of protest from market participants and rumored unconstitutional threats from an unhinged US president, the Fed should be congratulated for its steadfast commitment to policy “normalization.” It is finally confronting the beast that former Fed Chairman Alan Greenspan unleashed over 30 years ago: the “Greenspan put” that provided asymmetric support to financial markets by easing policy aggressively during periods of market distress while condoning froth during upswings.

Since the October 19, 1987 stock-market crash, investors have learned to count on the Fed’s unfailing support, which was justified as being consistent with what is widely viewed as the anchor of its dual mandate: price stability. With inflation as measured by the Consumer Price Index averaging a mandate-compliant 2.1% in the 20-year period ending in 2017, the Fed was, in effect, liberated to go for growth.

And so it did. But the problem with the growth gambit is that it was built on the quicksand of an increasingly asset-dependent and ultimately bubble- and crisis-prone US economy.

Greenspan, as a market-focused disciple of Ayn Rand, set this trap. Drawing comfort from his tactical successes in addressing the 1987 crash, he upped the ante in the late 1990s, arguing that the dot-com bubble reflected a new paradigm of productivity-led growth in the US. Then, in the early 2000s, he committed a far more serious blunder, insisting that a credit-fueled housing bubble, inflated by “innovative” financial products, posed no threat to the US economy’s fundamentals. As one error compounded the other, the asset-dependent economy took on a life of its own.

As the Fed’s leadership passed to Ben Bernanke in 2006, market-friendly monetary policy entered an even braver new era. The bursting of the Greenspan housing bubble triggered a financial crisis and recession the likes of which had not been seen since the 1930s. As an academic expert on the Great Depression, Bernanke had argued that the Fed was to blame back then. As Fed Chair, he quickly put his theories to the test as America stared into another abyss. Alas, there was a serious complication: with interest rates already low, the Fed had little leeway to ease monetary policy with traditional tools. So it had to invent a new tool: liquidity injections from its balance sheet through unprecedented asset purchases.

The experiment, now known as quantitative easing, was a success – or so we thought. But the Fed mistakenly believed that what worked for markets in distress would also spur meaningful recovery in the real economy. It raised the stakes with additional rounds of quantitative easing, QE2 and QE3, but real GDP growth remained stuck at around 2% from 2010 through 2017 — half the norm of past recoveries. Moreover, just as it did when the dot-com bubble burst in 2000, the Fed kept monetary policy highly accommodative well into the post-crisis expansion. In both cases, when the Fed finally began to normalize, it did so slowly, thereby continuing to fuel market froth.

Here, too, the Fed’s tactics owe their origins to Bernanke’s academic work. With his colleague Mark Gertler of NYU, he argued that while monetary policy was far too blunt an instrument to prevent asset-bubbles, the Fed’s tools were far more effective in cleaning up the mess after they burst. And what a mess there was! As Fed governor in the early 2000s, Bernanke maintained that this approach was needed to avoid the pitfalls of Japanese-like deflation. Greenspan concurred with his famous “mission accomplished” speech in 2004. And as Fed Chair in the late 2000s, Bernanke doubled down on this strategy.

For financial markets, this was nirvana. The Fed had investors’ backs on the downside and, with inflation under control, would do little to constrain the upside. The resulting “wealth effects” of asset appreciation became an important source of growth in the real economy. Not only was there the psychological boost that comes from feeling richer, but also the realization of capital gains from an equity bubble and the direct extraction of wealth from the housing bubble through a profusion of secondary mortgages and home equity loans. And, of course, in the early 2000s, the Fed’s easy-money bias spawned a monstrous credit bubble, which subsidized the leveraged monetization of housing-market froth.

And so it went, from bubble to bubble. The more the real economy became dependent on the asset economy, the tougher it became for the Fed to break the daisy chain. Until now. Predictably, the current equity market rout has left many aghast that the Fed would dare continue its current normalization campaign. That criticism is ill-founded. It’s not that the Fed is simply replenishing its arsenal for the next downturn. The subtext of normalization is that economic fundamentals, not market-friendly monetary policy, will finally determine asset values.

The Fed, it is to be hoped, is finally coming clean on the perils of asset-dependent growth and the long string of financial bubbles that has done great damage to the US economy over the past 20 years. Just as Paul Volcker had the courage to tackle the Great Inflation, Jerome Powell may well be remembered for taking an equally courageous stand against the insidious perils of the Asset Economy. It is great to be a fan of the Fed again.

Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University's Jackson Institute of Global Affairs and a senior lecturer at Yale's School of Management. He is the author of Unbalanced: The Codependency of America and China.