Yet another FOMC meeting has passed and the market continues to scrutinize the language of the FOMC statement for clues of what the Fed intends to do, heavily assuming that the Fed in fact knows what to do. The details will have been circulated ad nauseum by the financial press so we won’t delve into them here. Instead let us consider possibilities.

The market has been expecting the US Fed to raise interest rates, the timing is fluid but sometime this year seems to be the expectation. The Fed has to raise interest rates eventually if nothing else to reset an important policy tool. The strength of the US economy where employment is finally catching up to headline GDP growth is another factor. The current growth the US is experiencing is reminiscent of the mid 1990s Goldilocks (not too hot, not too cold, just right) economy, helped by depressed oil, energy and commodity prices. The weakness in the global economy is also helping the US grow without a pickup in inflation. China’s growth is decelerating, Japan is in recession and the Eurozone while recovering is barely clinging on to positive growth.

The consensus is therefore that the US has done with monetary accommodation and low rates while the rest of the world, stagflationary economies excepting, are in monetary loosening mode. What if the Fed was to postpone its rate hike? What would be the consequence? What is the likelihood? The USD could weaken. The consensus is for a strong USD and this is a very strong consensus. In the absence of a rate hike, the market could be quite unpleasantly surprised. The 10 year US treasury yield could move towards 1% and the 30 year to 2%. This could happen anyway while we wait for the rate hike. Fixed coupon issuance is likely to slow as tax receipts improve and debt is issued in FRN format. The demand and supply dynamics could flatten the curve.

Why might the Fed delay a rate hike? Low inflation might be one reason. 5 year 5 year forward breakeven which traded between between 2.4% to 2.6% has fallen steadily to 1.94% in Jan 2015. Deflation risk might stay the hand of the Fed. Slowing international growth is another possibility. The US is currently the main engine of growth. Of course people forget that the 7% growth rate that China puts out is a big number for a big economy, but even that number is shrinking. Latin America is flirting with stagflation. Brazil’s rising rates since March 2013 have not stopped the Real from steadily losing ground against USD. Europe has only just begun its money printing and debt monetization activities. If the European QE takes time to bite and Europe slows further, the US may not be able to raise rates for a while. In these scenarios, however, a weak USD is not likely since other currencies would be debased aggressively. Then there is the little question of the US treasury’s interest expense, currently 416 billion USD a year. A 0.25% hike in rates could, depending on debt maturities, issuance and impact on the term structure, result in interest expense rising some 50 billion USD, a 12% increase. Gently does it Janet.

The ECB, from pawnshop to used car dealer:

If you want to get more money out there into the economy, and get that money circulating instead of sitting in a dusty corner, you can’t just be a pawnshop. Lending cash against investment grade bonds is a pawnshop business, a.k.a. LTRO. Buying bonds in the secondary market is a used car business. You want to get the economy going, buy some new cars. Supplying money is one thing, stepping in where private demand is deficient is another. Buying used cars pushes used cars around at increasing prices making profits for other used car dealers but it does little for car manufacturers, output and employment.

And yet the ECB’s mandate excludes purchasing primary issues since this appears to be interference in fiscal policy. Purchasing secondary market issues apparently is not despite the issuers being clearly the same. Somewhere there is an argument that buying bonds from private holders does not explicitly bail out the issuers. True I guess. Bail out the holders of the debt, not the borrowers. Perverted but true.

Will QE work? The European economy is already recovering, so the timing of the announcement is fortuitous. Because trend growth globally, not just in the Eurozone, is slower than before 2008, policy will continually be miscalibrated. The European economy has slowed, but it has also very likely hit bottom and will recover. And now, the ECB and their QE will get the credit for it. On its own, QE would not have worked. QE depresses cost of debt, debt which nobody wants to incur. QE also depresses yields which are already well below US treasury yields. The analogy of pushing on a string was never more appropriate.

What is needed is more demand for goods and services, not more supply of credit. In the absence of private demand, governments need to target a budget deficit. Yet Europe is obsessed with fiscal restraint and budget discipline. What is ultimately required is a bond purchase program which is free to buy primary issue not only of sovereign debt but also of covered bonds and ABS. A To-Be-Announced mechanism of ABS and covered bond issues should be underwritten by an ECB asset purchase program. By actively encouraging demand instead of passively enabling it, policy makers might be able to awaken the moribund economy.

The current policy lifts asset prices but does little to address underlying demand deficiency and the failure of factor markets clearing. The ECB will simply have to do more later on thus fuelling a protracted asset boom while output and employment languish.

We remain positive on the outlook for China generally across risk assets.

1. Political reform is happening in the open and behind the scenes. At the Fourth Plenum, China elevated the constitution and announced the establishment of circuit courts free from local government influence.
2. Part of the reform is the wide scale anti-corruption effort which has ensnared some high profile officials previously believed off limits.
3. China is embarking on credit market reforms including eschewing blanket bailouts, encouraging more market discipline, regulating local government financing methods, prescribing collateral eligibility in swaps and repos. The recent policing of equity market margin trading is another encouraging measure.
4. Monetary policy has turned loose and is likely to stay that way. The PBOC reacted to US QE by tightening monetary conditions for the past 5 years expecting inflation. Inflation has abated and external economies are at risk of deflation. The PBOC has moved to compensate. Expect further macro prudential as well as traditional loosening.
5. The Chinese economy is slowing which is to be expected. That said, it is still the fasting growing large economy. The slowing economy will encourage the PBOC to be more aggressive.

The outlook is good for China risk assets. The investment strategy should be, A) avoid the obviously non viable, B) diversify among the remaining alternatives.

Draghi; Hi Tom. I’m going shopping next Thursday.

Jordan: How nice Mario. What are you buying?

Draghi: Nothing special. Just some high grade bonds.

Jordan: Really. How interesting. How much are you buying?

Draghi: Well, that’s the thing Tom. It sort of depends.

Jordan: Oh. On what Mario?

Draghi: Well, on how much YOU will be buying.

Jordan: I’m sorry? What was that?

Draghi: The exchange rate cap… Tom. Tom, are you there… Hello?

Could the ECB embark on a large scale bond buying program without consulting the SNB, which has been a large buyer of Euro sovereign investment grade bonds in order to maintain its currency cap? Of course not. The ECB would have to consult the SNB as to its intentions if it was to calibrate its own bond buying program size.

The fact that the SNB has abandoned its cap means that on Jan 22, the ECB will act with high probability and the program size is likely to be large, compensating for the fact the SNB will not be party to the purchase efforts.

Can you bail out a country by extending it more credit? Can a distressed entity borrow itself into solvency? The answer to both questions is, yes, but its hard. Greece seems to be expected to do so. In 2014 Greece has managed a primary surplus and is expected to repeat this performance in 2015.

1. 1. Greece stays in the currency union but defaults on its debt.

This Greece has done before in March 2012 when creditors exchanged existing bonds for longer dated ones with a 53.5% write-down of face value. Absent a better business model or an internal adjustment to domestic factor prices, expect more defaults.

2. 2. Greece stays in the currency union but has its debt restructured subject to austerity conditions.

This is what was the situation in 1 above was sold to creditors and the market. The restructuring above involved an exchange and a write-down. Absent a better business model or an internal adjustment to domestic factor prices, expect more debt restructurings.

3. 3. Greece leaves the currency union.

It would be irrational for Greece to leave the union without also defaulting on its Euro denominated debt. This would be the main perk for leaving the union. A new Drachma would re-price rapidly to adjust domestic factor prices so as to reflect productivity. It is likely that inflation would surge as the Drachma fell and Greece would be pushed into stagflation. Then it would recover. Without the crutch or shackles of the Euro, a flexible Drachma would adjust where domestic prices were sticky and factor and goods markets would clear. Absent a better business model… well, you get the idea. A country that defaults in Euros will default in Drachmas.

4. 4. Greece is ejected from the currency union.

The only reason Greece might be ejected from the currency union, apart from economic enlightenment, would be debt default. Actually, there is another reason but it is highly unlikely. The ejection of Greece would certainly encourage the rest of the union to take fiscal viability seriously. It is in Germany’s interest therefore to eject Greece before any default or bailout is negotiated. Such brinksmanship is highly improbable.

What does Greece want? Scenario 1 is most preferable for Greece. A debt write-down would be ideal for the debtor nation but this would leave Greece locked out of debt markets for some time. If the ECB had intended to buy sovereign debt in its recent plans for QE, a Greek default would certainly delay if not destroy such plans as questions would be raised as to the treatment of Greek bonds already on the ECB’s balance sheet. These bonds were not impaired in the first Greek debt exchange in 2012 and it is improbable that they would escape a write-down this time. Hold them at par and the recovery on the rest of the claims will be reduced. It would debase the entire “whatever it takes” pledge of the ECB.

What does Germany want? Fiscal rectitude and austerity on the part of Greece. Already it has leaked to the media its preparations for a Greek exit from the union, a leak which it subsequently quickly denied.