At the Humphrey Hawkins last night, the Fed Chair, Janet Yellen signaled flexibility on interest rates neither committing to be patient nor being more hawkish in the face of stronger labour market data.

The Fed has signaled that it is ready to raise rates this year as the US economy has shown strength and the labour market has finally caught up with output growth. However, inflation at 0.8% is far from the 2% target and recent labour market strength is unlikely to boost inflation for some time to come. The strength of the USD is another concern as it could hurt exports, yet the US is a fairly domestically focused economy with exports at 13.5% of GDP (2013 numbers but the ratio is quite stationary) according to the World Bank. One reason for raising rates is that under normal conditions, 0.25% is simply too low and the Fed has to reset its policy tool as well as signal some confidence in the US economy. Even 0.50% is not a high number and neither is 0.75%. Beyond that the Fed actually has no interest in raising rates since apart from the low inflation the debt service costs for the US treasury would rise (by roughly 30+ billion USD per 0.25% increase), as would corporate funding costs.

Let’s say for the sake of argument that the US Fed wanted to raise rates. It would need to do a couple of things. One, it would have to announce its intention and pick a number. Call it a 0.25% hike to take the Fed Funds Target Rate to 0.50%. The current effective Fed Funds rate is 0.12%, it is not 0.25%. In fact the effective rate has traded below the target rate since September 2008 when liquidity injections, bailouts and QE were applied. A positive gap between target and effective rates is a sign of the extent of excess reserves in the banking system. From 1985 to 2008 the gap averaged -3 basis points. From 2008 to the present, it has averaged +13 basis points. Incidentally this is a sign of the ineffectiveness of QE on the real economy. If the Fed wants to hike rates, it will first have to close the gap. It will need to reduce excess reserves in the banking system and has 2 instruments to do this. Term deposits and reverse repos. Term deposit take up has been slow with a take up of 188 billion USD on Feb 5, followed by a 107 billion Feb 12, and 107 billion on Feb 19.

Gone are the days when there was a Fed Funds Target Rate, today we have a target band of 0-0.25%. It might be embarrassing if the Fed announced a rate hike, and found the effective rate trading below the old target.

Equity and bond markets have been behaving well these past few years. Despite a slowdown in returns and a few wobbles towards the year end, 2014 was a fairly good year for investors. The MSCI World Index returned 4.8% while the Barclays Global Bond Index returned 3.8%. Clever positioning would have earned the average investor more, but even fairly obvious positioning would have earned an investor circa 6% without excessive risk or sophistication. With markets this sanguine one would expect the global economy to be good health. There are areas of concern.

Policy

The strength of the US economy relative to the rest of the world is resulting in a divergence in central bank policy. In a post 2008 world where central bank credit creation lacks extension to the private sector, countries are more sensitive to trade competitiveness. It would not go too far to say that the world has been engaged in a trade war since then. Today, the gloves have come off. Central banks no longer have the luxury of considering only the state of their own economies when they formulate policy, they have to take into account the policy decisions of other central banks, the state of other economies, and soon enough, the reaction of other central banks to their own policy decisions. This complicates an already difficult task, that of balancing growth, stable prices and the solvency and funding costs of their sovereigns. Central bank activity in the first 2 months of 2015 has been remarkable. The ECB announced QE, and a rate cut, before that the Swiss National Bank cancelled the cap on the CHF against the EUR and cut rates, the Reserve Bank of Australia, the Reserve Bank of India, the Bank of Canada, the Danmarks Nationalbank, and most recently Sveriges Riksbank, cut interest rates also. China’s PBOC cut bank wide reserve requirements having cut interest rates late last year and Singapore altered the trajectory of its currency policy in an effort to address low inflation. Russia has cut rates by 2% following a rate hike of 6.5%. in December 2014. A significant number of key interest rates and bond yields are now negative. The actions of these central banks are ostensibly to address the risk of deflation, however, currency devaluation is of limited use as currencies are all quoted one in terms of the other and the low inflation phenomenon is this widespread. The US will find itself having to balance the requirements of its domestic economy with the actions of all other central banks. The USD has been strong since mid 2014 and may be driven higher if as expected the Fed hikes rates in the middle of 2015. A strong USD will impair foreign earnings and terms of trade. One consideration the Fed will be making is how important the export sector is to the US. In the past the US ran a large negative trade balance but this has receded with re-shoring and growing energy independence. A more self sufficient US might be able and willing to pivot towards a more insular trade policy. A strong USD may have unexpected consequences. It can steepen emerging market term sovereign term structures and cause interest rates to rise. Non dollar debtors borrowing in dollars could be impacted as well. Some of these are well documented phenomena but there will be other less expected ones.

A more important but apparently less pressing question is how central banks normalize policy once their economy has reached a state of normalcy. Here the US Fed is an excellent case study being the only central bank with a robust economy, and having an acutely inflated balance sheet. Rate hikes may be determined by the strength in the economy, but the side effects have to be considered and tested for, something the Fed has been doing using term deposits and reverse repos since Oct 2014, seeking feedback on the desired level of reserves by the banking system. So far the results have been inconclusive. Then there is the question of when it will begin to actually shrink its balance sheet. This is the bigger question which will likely come to the front at some point.

Debt

Following the crisis of 2008, much debt was transformed and or transferred to more stable holding vehicles such as rescue funds, central bank or state balance sheets shielding them from price discovery. At the same time, massive bail outs and central bank money printing have depressed borrowing costs. While one sector deleverages, another leverages up. As one country deleverages, another leverages up. Generally, developed world economies have increased already high levels of leverage. Developing economies are catching up, albeit from much lower levels. The charts below illustrate debt levels, which are already high, but exclude unfunded liabilities such as pensions and health insurance. In developed economies, such unfunded liabilities can add a multiple or two of GDP to the already high levels of total debt. A population does not merely borrow from others, it primarily borrows from its own future; debt is an inter-temporal transfer. It is essential that the future productivity of the population is sufficiently high to repay its obligations. As it is, government debt looks like PIK debt, paid off either with new debt or with the proceeds of new debt. Only sufficient economic growth can, with time, reduce the debt burden.

Demographics

Economic growth is dependent on demographics, among other things. The rich world is generally an ageing one and the developing world, a young one. That the developed economies are the most leveraged is not encouraging. A high debt burden required economic growth, but economic growth is dependent on the steady
growth of the labour force or its productivity. Japan is an example where an ageing population is resulting in slower growth and falling tax receipts. The government’s approach to spurring growth is to spend and borrow, a strategy that requires that the spending spurs more growth than it does accumulate debt. Otherwise, the stock of debt will only grow. With deflation as well, the real value of the stock of debt also grows.

Distribution Of Wealth

One of the surest and most topical trends has been the distribution of wealth. Inequality between countries has ebbed as poor countries caught up to advanced economies while inequality has risen within countries. This is in part a consequence of globalization where inter country wealth would be expected to converge while in-country inequality is boosted by capital and labour mobility. The efforts of central banks to boost economic growth by QE has created asset price inflation leading to the enrichment of asset owners, generally the more well to do. The fortunes of workers has lagged. Simultaneously, labor’s share of output has fallen steadily and certainly accelerated downwards in the recent decade or so. This is not a universal phenomenon but certainly holds true for the major economies and globally in aggregate.  Income inequality dulls fiscal and monetary policy, skews labour supply, and influences politics. Acute imbalances in the distribution of wealth and the share of profits can only trend so far before they threaten the social compact and the status quo. At that point, the capitalist and democratic ideology may be challenged and fundamental regime change could occur.

In closing:

These are selected long term fundamental issues that lay in front of us. Some of these issues lie further in the future but others are more immediate. It is rational to deal with the immediate issues first, just as it is human to deal with longer term issues later, when they become immediate and have accumulated scale and intractability.

For financial markets the response is, how can one make nominal financial profit in the short to medium term. For individuals, this is a rational response since they lack the ability to individually affect policy to address longer term, collective reform.

Relevant trading and investment strategies, and more importantly, loss avoidance strategies will be covered in the coming weeks.

The economy has a natural rhythm, a natural metabolism, a natural rate of growth. These growth rates are determined broadly by the endowments of natural resources and the people, how many there are, how quickly they grow, their age distribution, and their intellect and enterprise, and the tools which were made by these people to make other things. To aid the transfer and storage of resources and capital, we introduced money, and with it a great deal of complexity. Yet behind the complexity of finance, the natural rhythms continue.

With time, highly intelligent people decided that they could alter the rhythm and the rate of economic activity. They sought to dampen the cycle and to increase the rate of growth. But in every dynamic system, exogenous forces ripple through the endogenous forces. Cycles are difficult to dampen, and what looks like success can be an accumulation of latent instability. Without acknowledging the long term natural growth rates of an economy, fiscal policy and monetary policy can be likened to pushing or pulling a cripple along, soon he stumbles, his feet are dragging on the floor and policy may need to bear the full weight of an inanimate body.

There are many analogies of where extraordinary analgesic measures are applied to artificially boost performance or delay demise. The concept of a bail in is an odd one. A corporation is capitalized with equity and debt. The priority of claim is well defined. Equity is first in line to take losses and profits. Debt is second in line for losses, and earns a fixed interest. Debt itself can be sliced into different layers, junior claims and senior claims. When a business becomes insolvent, equity takes first loss, then junior debt then senior debt. In the case of banks, for a host of reasons, depositors, who are senior unsecured creditors, are often bailed out. Where they are not bailed out, they are considered bailed in. A bail in is seen as an extraordinary event when in fact, in the absence of a bail out, the appropriate extraordinary event, a bail in is the normal course of assigning residual value to claims.

Much of modern medicine is to do with interfering with the course of nature to prolong and extend life beyond its natural limits. Consider the implications if in the limit we were able to prolong life indefinitely. The planet might struggle to support the population. Genetically modified foods have their advantages and side effects. For every action there are side effects. Not all bad it should be said. Examples abound where our solutions to existing problems only transform or transfer the problem spatially or temporally.

“Neither a borrower nor a lender be; For loan oft loses both itself and friend, and negative yields dulls the edge of policy.”

Now many countries are both.

10 year Swiss and German government bonds currently carry a negative yield. When one moves to shorter maturities, such as 2 years, we find that France, Germany, Sweden, Netherlands, Switzerland and Japan all trade at negative yields. This means that investors, if you can call them that, pay to lend to these governments. One species of large investor willing to pay to lend is the central bank.

So far the negative yields have not been a phenomenon of primary issuance, save in a few circumstances such as Japan. This example is interesting because it pays the issuer to issue. The more issued, the more solvent the issuer. All this needs is a sufficiently motivated lender, the central bank.

Imagine a more extreme example of a negative coupon bond. The only investor willing to buy such an instrument would be the issuer, or their central bank. The mathematics of such an issue would require the suspension of disbelief. The issuer would be paid to borrow and the more the borrowing, the more the payment. At last it would be possible to borrow oneself into solvency, surely the Holy Grail of public finance. The buyer would, however, guarantee themselves a loss. Any other institution than a central bank could therefore lend itself into insolvency if the size of such lending was sufficiently large. Central banks, however, are special. They can meet obligations by creating money. All this is of course a circuitous route for a government seeking to spend and fund its spending with bits of paper.

So far the money creation has not multiplied through the economy to encourage economic growth. Instead the velocity of circulation of money has slowed, nullifying the money base expansion. Why is this? It is hard to tell but one possibility is that the transactional demand for money simply isn’t there. Consumers are cautious and businesses are sceptical. Trade is complicated by competitiveness, policy and productivity. Governments could spend. If, however, despite the largess of their central banks, governments, for ideology or other reasons, decide to rein in spending then it is no wonder that output and employment languish. A practical case in point is the ECB’s bond buying program. While the scale of the program is large, by requiring Member State’s conform to the Maastricht debt criteria, the EU is neutralizing QE. So QE works if it monetizes debt incurred when the government spends on behalf of the private sector and is much less effective if the government does not.

If a country can borrow at negative rates of interest, expand its central bank’s balance sheet without bound and target a budget deficit to replace deficient private demand, what is the cost and what are the limits?

Private and external investors may be discouraged from buying bonds. This can impair liquidity and price discovery in the bond market. God forbid anyone should discover the true price of a bond. With negative interest rates, investors will naturally seek alternative stores of value. Central banks inducing negative interest rates may find themselves the sole buyers of their sovereign’s bonds. Captive domestic investors may not have the luxury of directing their capital elsewhere. Examples of this are state pension and social security funds. If private investors are discouraged from buying bonds it means that central banks will have difficult exits and find it painful to reduce the size of their balance sheets. Any reduction of central bank bond buying would lead to higher yields. The US experience today confounds this analysis but here, a stabilizing budget and the changing structure of treasury financing are responsible for keeping yields low. And, yields may still rise for we are still in uncharted territory. The US is in fact further along this path than their brethren. The Fed’s balance sheet has only shrunk in the last two weeks having peaked at USD 4.516 trillion on January 14.

The currency might weaken. This can improve the competitiveness of the country’s exports but can also import inflation through higher input prices. Yet not everyone can be a net exporter, try though they might. Since 2008 countries have tried to debase their currencies in an effort to improve competitiveness and export their way to recovery. Weakening a currency is a risky strategy since excessive weakness brings its own problems. Hyperinflation is seldom the consequence of bad economics. They are the consequence of a failure of confidence, a failure that is often the consequence of bad economics. A beggar-thy-neighbour strategy requires a steadily declining currency. A volatile and acutely weak currency can lead to capital flight, spiking interest rates and end in capital controls and market failure.

Confidence is one of the most important factors in finance. Loss of confidence can lead to acute acceleration of trends leading to currency crises, credit crises and hyperinflation.

Efficacy. The intent of policy is to revive private demand. Government spending can improve headline output but can also crowd out private demand with little impact on private output and employment. The poor efficacy of multiple rounds of QE in the US is illustrative. While the money base was expanded nominal output languished as the velocity of circulation fell. The private economy has a natural metabolism which cannot easily be accelerated simply by association. There was simply no multiplier effect to the government’s fiscal efforts to boost the economy as liquidity was soaked up by saving.

Artificial depression of interest rates across the term structure are intended to reduce borrowing costs, but if rates were already low, policy may be pushing on a string. Again, the private economy’s natural metabolism cannot always be accelerated by the provision of cheap credit. ‘Build it and they will come’ doesn’t translate well into ‘offer to lend and they will borrow’.

Nominal output may grow but there is no guarantee that real output will grow. The growth might be entirely in prices, that is inflation. Moreover, nominal output would include all goods and services as well as assets. The growth may manifest more in asset price inflation. Asset price inflation supported mostly by liquidity and a dearth of viable alternatives can easily be deflated in disorderly fashion.

Nobody knows what market prices are. For factor inputs, assets or goods and services. As a result, certain markets will not clear. When central banks buy sovereign bonds they impact prices. In order to avoid acute price distortion bond purchase programs may have limits on how much of an issuer’s total debt or how much of a particular issue or issues in a particular maturity range may be bought. This is not effective because apart from the direct impact on pricing central banks’ intentions signal to the market future demand leading the market to react accordingly. This may be helpful at the initiation of a bond purchase program as the market aids the central bank in depressing borrowing costs but can be less helpful on the exit. For the central planner the price distortion is a difficult problem. Since the market price absent intervention is unknown, the impact of withdrawing from intervention is unknown. This uncertainty discourages central banks from exiting intervention until it is too late.

Some tidbits:

In a sense, central banks are going back to their roots. The Bank of England was established in 1694 to fund William III’s defence spending. The government issued debt of GBP 1.2 million, which was subscribed by the bank in a very modern QE type move, and carried an interest rate of 8%, which would surely have sunk modern United Kingdom. What was different was that the Bank bought a primary issue loan and the government promptly spent it building a navy. Imagine if the government was told to maintain a 3% budget deficit limit.

The world’s oldest central bank, the Riksbank, was established in 1668. Its predecessor was Stockholm Banco, whose founder Johan Palmstruch was condemned to death for bankrupting the bank through over issuing bank notes; he was later pardoned and is today unconsciously emulated by most fashionable central bankers. Riksbank was the first bank to use negative interest rates, lowering its deposit rate to -0.25% in July 2009. Its motto is Herefore Strength and Safety.

You may now stop suspending disbelief.