Credit - Chekhov's gun

"One must never place a loaded rifle on the stage if it isn't going to go off. It's wrong to make promises you don't mean to keep." -  Anton Chekhov

Listening with interest to our "Generous Gambler" aka Mario Draghi monthly ECB conference, where no doubt, our poker player has indeed regained some of his "Sprezzatura", given the dovish surprises contained in his latest press conference with his explicit reference to the planned balance sheet expansion of the ECB in the introductory statement, we reminded ourselves of Russian writer Anton Chekhov's dramatic principle when choosing this week's analogy given the continuous hope for the ECB to unleash at some point a QE program of its own:
"Remove everything that has no relevance to the story. If you say in the first chapter that there is a rifle hanging on the wall, in the second or third chapter it absolutely must go off. If it's not going to be fired, it shouldn't be hanging there." - Anton Chekhov

One could argue as well that Chekhov's analogy amounts simply to Tuco's philosophy from The Good, the Bad and the Ugly:
"When you have to shoot, shoot. Don't talk" - Tuco

And when it comes to central bankers, it looks to us that Bank of Japan has indeed recently applied Tuco's recommendation when it comes to its latest merry go round of QE but we ramble again...

Of course this post is a continuation of what we discussed in our last conversation in relation to the need of QE in Europe:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility." - Martin Sibileau

Therefore in this week's conversation we will discuss into more details the need for a European QE and the potential effects the various QEs have had on the real economy.

When it comes to QE and its impact on asset prices, we have largely discussed its effect in our September 2013 conversation "The Cantillon Effects":
"Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

We also commented at the time about the increase of money supply on the art market as posited by our friend Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":

"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

It is was therefore not a surprise for us  to hear that a Portrait by Edouard Manet reached $65M at a fall art sale in NYC, making this auction a new record for the artist (the previous record was $33.2 million for a Manet). Sotheby's sale totaled $422.1 million, the highest for any auction in its history. This is yet another sign of central bankers' "generosity" and a clear effective mean of measuring "Cantillon Effects". As per our previous conversation, a clear application of "Pascal's Wager":

The only "rational" explanation coming from the impressive surge in asset prices (stocks, art, classic cars, etc.) courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods".

Back in September 2012, in our conversation "Zemblanity", (Zemblanity being defined as the inexorable discovery of what we don't want to know), we discussed the relationship between credit growth and domestic demand and why ultimately our central bankers will fail in their useless reflationary attempts:
"credit growth is a stock variable and domestic demand is a flow variable"

We even asked ourselves at the time the following question:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

The importance of domestic demand being a flow variable should not be underestimated particularly in the case of Europe due to the lack or slack in aggregate demand thanks to high unemployment levels and in many cases what Richard Koo has coined as "Balance Sheet Recession" (think Spain and Ireland when it comes to real estate bubbles and "damaged" households balance sheet).

As a reminder from our conversation "Zemblanity", it is very important to understand the core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org from their post entitled - How central banks contributed to the financial crisis: "We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b). 
 To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit."  - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org

So you might wonder where we going when it comes to discussing "Chekhov's gun" and the impact QEs have had on real economy, Japan being a good illustration.

On that specific case, we agree with Richard Koo, chief economist at the Nomura Research Institute in his latest note from the 11th of November entitled "BOJ's surprise announcement: monetary easing by a currency interventionist":
"QQE has had almost no impact on real economy
What effect has QQE had in the 18 months since it began? It has clearly had a major influence on the forex and equity markets, where surprises can be very effective tools, but has had almost no impact on the real economy.

Figure 1 shows Japan’s monetary base, the money supply, and domestic bank lending before and after QQE. If we rebase these aggregates to 100 at the point just before Mr. Kuroda became head of the BOJ and announced QQE, we can see that while the monetary base had surged to 187 as of this October, the money supply—the money actually available for the private sector to use—had risen only to 105, while bank lending stood at 104. Indeed, the money available for the private sector to use is expanding no faster than it did under Mr. Kuroda’s predecessor, Masaaki Shirakawa, in spite of QQE. In other words, QQE had no effect on the growth rates for either of these aggregates.

Central bank-supplied liquidity has nowhere to go without real economy borrowing

As I have repeatedly pointed out, the central bank can supply as much base money (liquidity) as it wants simply by purchasing assets held by private-sector banks.

But a private-sector bank cannot give away that liquidity, it must lend it to someone in the real economy for that liquidity to leave the banking sector.

For the past 20 years, Japan’s private sector has not only stopped borrowing money but has actually been paying down existing debt and increasing its savings in spite of zero interest rates.

Traditional economics never envisioned this kind of behavior, but the collapse of debt financed bubbles in Japan in 1990 and the West in 2008 left many businesses and households owing as much or more than they owned, prompting them to focus on repairing their damaged balance sheets.

QE without private demand for funds only generates mini-bubbles

While Japan’s private sector finally cleaned up its balance sheet around 2005–06, the debt trauma lingered on. That, together with the collapse of Lehman Brothers in 2008, led to a situation in which Japan’s private sector is still saving 5.7% of GDP in spite of zero interest rates and aggressive quantitative easing.

Unless the government borrows and spends this 5.7%, the funds supplied by the BOJ under quantitative easing would never leave the banking system and neither the money supply nor private credit would have increased—in fact, they might actually have decreased.

No matter how much the BOJ eases policy during this kind of balance sheet recession, the liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. The only result is likely to be the creation of mini-bubbles in the financial markets.

While funds supplied under quantitative easing may provide a temporary boost to the prices of stocks and other assets, at some point those prices will correct unless they are justified by corporate earnings growth and other appropriate measures, and that will be the end of the mini-bubble." 

- source Richard Koo, Nomura Research Institute

If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.

In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.

Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.

In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play.

In the case of Europe, deflationary forces can be ascertained by slowing global trade in the shipping industry as we discussed in our conversation of  January 2013entitled "The link between consumer spending, housing, credit and shipping - a follow-up":
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".
Any changes in consumer spending will directly impact global containerized traffic volumes. Containerized traffic is dominated by the shipment of consumer products."

The latest warning in slowing global trade sent across by shipping leader and giant Maersk as reported in the Financial Times in their article entitled "Maersk warns of slowing global trade" should not be ignored:
"“We see a slowdown in emerging markets, partly driven by a lower need for raw materials from China. Europe – it’s very slow growth, if any, at the moment, and there’s no reason to expect a big change here,” said Nils Andersen, Maersk’s chief executive." - source Financial Times

As indicated by the weaker outlook in shipping for Europe, QE on its own will therefore not be sufficient to have an impact on the real economy given the "japanification" process at play and as illustrated by Japan.

On the subject of the risk of continued QE and its negligible impact on AD and the real economy, we read with interest RBS's take on the subject in their note entitled "The Silver Bullet - The risks of QE infinity:
"The supporting idea for QE is that a positive wealth shock can support spending and confidence, and absorb other negative shocks to the economy. But what happens if QE continues, and consumers expectations' adapt to a QE-after-QE environment? 

In a basic (rational) economic model of consumption, households try to maximise lifetime income, i.e. the maximum value they can achieve with their wages. In a QE infinity world with stable/low interest rates and flat/negative inflation, the price of goods stays stable or declines over time, while the value of financial assets is expected to grow. The incentive for those holding financial assets can become to delay spending or investment. 

There are of course many factors in play when it comes to consumer spending and corporate investment decisions: expectations of long term permanent income, the life cycle, interest rates, confidence, etc. 

But there's consistent evidence across some points:

1. Rich people save more and spend less. There's plenty of historical evidence on this. As we show in the chart above, the saving rate for the top 1% and top 5% of the population is a multiple than the bottom 50% (see also  Do the Rich Save More?). 

2. Income inequality has increased since the crisis. The share of wealth owned by the top 0.1% is now over 20% in the US, vs around 15% in the 2000s. Inequality measured as such is as high as it was in 1916, according to the  Economist. The  debate still goes on, but there's evidence that QE may have contributed to rising inequality, and central bankers including the Fed are becoming more vocal on the topic.

3. The marginal impact of an increase in wealth to translate into consumption is lower for the richer brackets of the population. A recent ECB paper shows this clearly: as you can see in the chart above, the propensity to spend if wealth increases is 2-3x higher for the bottom 50% of the population.

4. Even when it comes to corporate investment, there is little relationship between QE and lower interest rates and more investment, which instead depends on other factors (economic outlook, fiscal policy, etc.)

Adding up points 1-4 highlights one risk. If QE is accompanied by other policies – like fiscal spending or a reduction in taxes – then it can work effectively. But if central banks are left alone with the burden of stimulating the economy, the risk of entering a cycle of QE after QE, or QE infinity is high, and the results can be self-defeating. 

For now, credit investors continue to anticipate more action from the ECB (and BoJ) – the next one being potential purchases of corporate bonds. But the impact on the real economy still depends on government action on spending, and support to the ABS programme, and so far we have seen little of it. 

Our view here remains: don't confuse QE with growth. If anything, QE infinity could be self-defeating without fiscal and reform support, as the ECB itself has warned. We expect more tightening in investment grade and double-B bonds on potential ECB action, but fundamentals for banks and lower-rated firms will remain weak into year-end and 2015, hurt by deflationary and weak growth (IFO institute head Hans Werner-Sinn just warned about an economic crisis being "really close", even in Germany).The ECB ABS plan is potentially a game-changer, and the ECB may start buying over the coming days, as Yves Mersch said yesterday. Let's hope that this time around, they'll get some help from governments." - source RBS 

Our take on QE in Europe can be summarized as follows:

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?

When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend as indicated by Nomura by Alastair Newton on the 11th of November in his note entitled "Civil unrest: Going global - More economies look prone to protests":

"Common factors

The (largely) common factors remain those I identified last year, ie:

-A high level of economic inequality (using the World Bank’s assessment of individual economies’ Gini coefficient);

-A high level of perceived corruption (using Transparency International’s (TI) index);

-A 'local' – sometimes minor and often hard to anticipate – issue sparking widespread protests rooted in general unhappiness with the regime;

-Increased 'middle-classing' of civil society, often confirmed by a ‘core’ of the protestors being in or having had tertiary education;

-Effectively leaderless protests organised primarily over social networks, ie, in common with the 'Arab Spring';

-A shared sense among the protestors of not being listened to by allegedly corrupt and self-serving elites;

-Widespread protester use of mobile phone cameras in the 'propaganda war'; and,

-Allegations of police brutality escalating, rather than deterring, the protestor numbers.

As the recent demonstrations in Hungary underline, we should not assume that civil protest is limited to emerging markets. Notably in many EU countries we are increasingly seeing what are essentially protest parties capturing a significant share of the popular vote in elections. In 2015, look out in particular, therefore, for UKIP in the 7 May UK general election and for Podemos in Spain’s December elections (not forgetting the – related, in my view – drive towards independence in Catalonia)." - source Nomura

Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)

On a side note and on this "French" matter, we think it is time to revisit our August 2012 OAT / Bund Yield Spread Widener as per our conversation "France - Playing the nonchalance". While we highlighted at the time the lack of catalyst, this trade had been put in the drawer given market capitulation and Japanese investment support in buying French bonds.

We still believe France should be seen as the new barometer of Euro risk, particularly when one realizes that France will issue €188 billion of bonds in 2015 (same record amount as in 2010) and for the following reasons:

-The European Commission latest macroeconomic forecast for France expects a budget deficit of -4.5% in 2015 and -4.7% in 2016. France will be the worse European country in terms of budget deficit. If indeed global trade is slowing down, there is indeed a high probability the deficit could even reach the important psychological level of 5%.

-With the recent comments from Hedge Fund manager David Einhorn, fast money could potentially put back the trade on.

-While Japanese investors have in the past been very supportive of French OAT bonds, the real yield of US Treasuries (0.6%) in conjunction with a rising US dollar make the US bond market much more appealing than the French bond market. 

As a reminder from our conversation "Big in Japan", Japanese have been net buyers of OATs in 2012 to the tune of 4.07 trillion JPY (44.2 billion US), the most since 2005. The gain in yen was 26% versus 15% for US Treasuries and they only bought for 3.35 trillion JPY worth of US debt in 2012.

This makes more likely a slowdown of the Japanese support for French OAT bonds in 2015. If one looks at GPIF assets and expected changes in portfolio allocation as displayed in Nomura's Japan Navigator number 593 published on the 3rd of November, the greatest change will be on international stocks rather than international bonds:

- source Nomura

French 10 year OAT vs German 10 year Bund - graph source Bloomberg:

On current levels, this trade appears to us very "convex". Downside appears to us limited to 10 bps, roughly 1 point on OAT Futures on current sensitivity levels, carry is around -35 bps over one year. One can target 20 to 50 bps of widening in the next 6 months if indeed there is finally a catalyst playing out. One could as well play the trade flat carry by buying more German bund, which would of course be an even more bearish growth outlook trade. Why not...

This trade could be seen as a little convex trade versus a book of high beta risky assets (periphery credit, equities, etc.). 

Moving back to our "Chekhov's gun" theme of European QE and in the case of Europe, the equity rally that followed the press conference of Mario Draghi doesn't appear warranted as it seems to us that investors have jumped the proverbial "Chekhov's gun". On this subject, we agree with Deutsche Bank's Behavioral Finance Daily Metals Outlook note from the 7th of November entitled "The far-out-of-the-money Draghi Put:

"Anyone who thought Mario Draghi would strike a more conciliatory tone in yesterday’s ECB press conference, following a Reuters report of dissatisfaction with his leadership style among members of the Governing Council, was doubly unsettled. Not only did he not backpedal on any of his more contentious statements about QE and the future size of the Bank’s balance sheet, he even made them more explicit, and presented an endorsement of his stance signed by all members of the Council. This dovishness lit a fire under European asset prices. Equity benchmarks rallied strongly as investors priced in the prospect of broad-based asset purchases. This reaction was perhaps overenthusiastic because the pre-condition for QE is that the economic situation in the eurozone worsens and/or that the current measures prove inadequate (which means precious time would have been spent finding out). So a ‘Draghi Put’ exists, but it is struck far-out-of-the-money. Even gold in euro terms recorded its first positive session in over two weeks.

But it was far from being the most sought-after asset of the day; investors still preferred the dollar and US-based assets. If the global economic situation becomes gloomier, they reasoned, the Fed would probably still take more aggressive action than the ECB, and sooner. The strike price of the ‘Yellen Put’ is much closer to the money." - source Deutsche Bank

Indeed, when it comes to the ECB we have a case of "Chekhov's gun, whereas when it comes to the Fed and the Bank of Japan it is more akin to Tuco's philosophy: "When you have to shoot, shoot. Don't talk"

What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:
"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.
Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).
Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members.

Kuroda abandons forward guidance
It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time.
Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants.
But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ’s toolkit.
When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making “steady progress” towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed
The BOJ governor’s decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market—including forward guidance—is essential when winding down such a policy, as the IMF has repeatedly warned.
There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharply
higher.
The Fed’s intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation.
In summary, the BOJ’s shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed." - source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured.

While it has been easy to somewhat front-run the QE cowboys thanks to "Pascal's Wager", the end of QE in the US coincide with a renewed period of weaker global trade, historically high asset price levels and record low bond yields making it more likely we will see a return of higher volatilities regime in the near future making future equities return questionable and long bond US Treasuries enticing (we are keeping on our very long duration exposure via ETF ZROZ).

On a final note we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled "Humiliation, Hubris & Gold" displaying Japan's free-float market cap as a percentage of world:

"Tokyo's all-out War against Deflation
Finally, Japan’s humiliating decline as % of world market cap (Chart 10) and the explicit war on deflation launched by the Bank of Japan keeps us overweight Japan, in contrast to China and Europe. In addition, Japan has high operating leverage and stronger earnings momentum. Our bullish view on volatility, particularly currency volatility, is strengthened by the knowledge that liquidity trends in the US and Japan will be moving in different directions over coming quarters." - source Bank of America Merrill Lynch.

"Every gun makes its own tune." - Blondie, The Good, the Bad and the Ugly

Stay tuned!

QE - To infinity ... and beyond!

"The last proceeding of reason is to recognize that there is an infinity of things which are beyond it. There is nothing so conformable to reason as this disavowal of reason." - Blaise Pascal, French philosopher

Apologies dear readers for not having posted recently our credit ramblings, but, once in a while, bloggers such as ourselves are in the need for some R and R (Rest and Recuperation). This is exactly what we did. We rested our mind while enjoying some wine tasting in the United States. Of course, one would immediately turn their initial thoughts on California. Luckily the immensity of the United States means diversity, and we found ourselves enjoying Long Island and its many wineries as well as a particular Paumanok 2005 Cabernet Franc but then again, we fall prey to our usual rambling habits. 

Following up on our recent conversation entitled "Zemblanity", and "The inexorable discovery of what we don't want to know", we could not resist to refer to Buzz Lightyear's catchphrase from the Toy Story franchise in our title as another reference to the unlimited pledge in Quantitative Easings by the Fed and the continuous game of global "easiness" provided by most Central banks across the globe (Fed, BOE, BOJ, ECB). In this post we will revisit the consequences of unlimited QE.

Buzz Lightyear of Star Command (central bankers), space ranger protecting the universe from Evil Emperor Zurg (deflation):

While Buzz Lightyear was indeed the most popular toy in the first outing of Toy story, it looks to us that currently QE is the most popular toy being used by our central bankers over the world. But, in similar fashion to our Buzz Lightyear from the movie Toy Story, it looks to us that central bankers are indeed as deluded as Buzz Lightyear was. Buzz Lightyear in the first movie believed he was a space ranger before realizing he was just a toy. It appears to us that, courtesy of "Zemblanity", at some point, central bankers will have indeed to realize that QE is just a toy and a dangerous one to play with for too long in fighting Evil Emperor Zurg (deflation). This is clearly illustrated by Japan's plight in fighting off "Zurg" for the last 25 years as indicated by Bloomberg:

"The Bank of Japan’s failure to halt yen gains through domestic bond buying over the past decade is pushing policy makers to consider a new tack, purchasing foreign debt to produce the currency weakness exporters crave. The CHART OF THE DAY shows the yen’s effective exchange rate climbing to about 5 percent above its 10-year average, ignoring BOJ asset purchases that helped swell the money supply to 124.33 trillion yen ($1.6 trillion), the most ever in data going back to 1970. Policy makers’ efforts are faltering as bank lending dropped 3 percent from a six-year high reached in March 2009, preventing the cash injected into the financial system from filtering into the wider economy. Buying foreign bonds is a promising tool, Economy Minister Seiji Maehara said this week, echoing the two newest BOJ board members who’ve said new types of easing should be considered. BOJ Governor Masaaki Shirakawa said such purchases would be a type of currency intervention, which only the government can do. The BOJ starts a two-day policy meeting today. “Current policy tools are reaching their limits in ending deflation and yen appreciation, increasing political pressure on the BOJ,” said Koji Takeuchi, senior economist at Mizuho Research Institute. “Purchases of foreign bonds are being considered, which would require changes to the central bank charter.” The yen traded at 78.48 per dollar as of 8 a.m. in Tokyo from 78.49 yesterday. The currency reached a post World War II record of 75.35 per dollar on Oct. 31, 2011. The yen’s 14 percent climb over the past three years is reducing earnings at exporters." - source Bloomberg.

The approach of "infinity...and beyond" has been clearly demonstrated by our "Buzz" Central Bankers' willingness in committing to maintaining interest rates at zero for a long period. In Japan's case, the BOJ has promised to keep rates at or near zero until inflation reaches a certain level, and thus close to an "inflation target". "To infinity and beyond!"...One may posit, as Japan has been playing with its QE toy for the last 25 years.

In a recent note published by Nomura Securities entitled "Lessons from Japan" - Securities Investment in a Low-Yield, Low-growth Environment from the 2nd of October 2012, they indicate the following:
"Japanization trades in rates markets BOJ measures were in response to falling growth and inflation expectations The roots of Japanization lie in the substantial declines in growth and inflation expectations (graph below). This process took place over more than 10 years, starting with the financial bubble burst in the early 1990s – the BOJ’s policy duration and QE measures appear to have had a direct effect on JGB price action, but the BOJ only responded to the low growth and inflation environment." - source Nomura.

"Government bond markets mean revert under policy duration regime Policy rates are the starting point in shaping the yield curve. As these rates are likely to be kept close to zero for a prolonged period, government bond yields will likely be anchored as if to mean revert, with their volatility falling (see below graph). As such buying maturities with high carry and roll on dips (i.e., on yield upswings) and holdinh onto them may appear the best option as  long as the low-rate commitment remains in place." - source Nomura.

Unintended consequences of playing too long with a QE toy:
"Inflows of short-term capital create bond bubble 
In addition to long-horizon trades for carry and roll, government bond markets attract large amount of flows seeking short-term gains, which have resulted in yield curve shapes that are significantly flatter than the ones justified by the expected growth and inflation rates. When central banks buy government bonds as part of QE measures and thus tighten supply and demand in the market, government bonds are likely to outperform other assets due to capital gains, attracting further inflows of short-term capital. Moreover, this kind of rally is likely to be bolstered by optimistic views on market fundamentals that justify the low-rates regime (for example, the central bank will keep policy rates low further into the future, and the economy will become increasingly deflationary)." - source Nomura.

We agree with the above.

Nomura also made an important point in their note from the 2nd of October 2012 relating to the Taylor rule. A Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle):
"Undue reliance on policy duration may be risky
Considering that monetary policy measures are devised in response to changes in the macro backdrop, we should not ignore the impact that a low growth and inflation regime has had in shaping the government bond market and monetary policy, i.e., the concept of the Taylor rule. For that matter, we note that the Fed’s current forward guidance indicates that it will keep fed funds rates at ultra-low levels through “mid-2015,” but this is quite a bit later than the timing that would be deemed appropriate according to the Taylor rule*. Although the BOJ has set achieving 1.0% CPI inflation as its policy objective and thus has not specified the time until which it will keep the current policy in place, the market’s expected policy duration has been extended close to historical levels, after which sharp JGB sell-offs have followed – we doubt that such high expectations can be sustained as the economy begins to pick up." - source Nomura.

*Based on the current output gap and the Fed’s economic projections, the Taylor Rule would suggest that the Fed’s ZIRP should continue only until early 2014.

Some may put too much hopes that our "Buzz Lightyear" central bankers have designed an escape capsule from their "infinity...and beyond" policies.

We also agree with Nomura's chief economist Richard Koo in his most recent publication "Reconsidering quantitative easing" published on the 2nd of October, namely that one should not put too much hopes on the escape capsule:
"Perceived limits on fiscal policy increase pressure on monetary policy
In spite of these experiences, the baseless view that fiscal policy has reached its limits has come to dominate the debate in many countries, including Japan. That, in turn, has placed a great deal of pressure on central banks and led them to inject a sea of liquidity into the market when there is no reason why more liquidity should have any effect. 
This liquidity will create no problems as long as there is no private demand for loans, since the funds essentially sit in the financial system. 
The problems come when private demand for loans returns to normal levels and those funds resume circulating. 
Central banks must tighten aggressively when loan demand picks up 
As soon as private loan demand recovers the central bank will have to mop up the excess liquidity, which is currently running at two to three times the normal level. Otherwise prices could double or triple. 
But to do so the central bank must sell the bonds it bought, putting upward pressure on interest rates just when the private sector is ready to borrow money again. 
The Fed, for example, will have to sell $1.4trn in bonds when conditions in the private sector return to normal, at a time when the economy is recovering and businesses and households are becoming sensitive to interest rates. 
And if the market decides that the central bank is not mopping up excess liquidity fast enough, that alone could lift private inflation expectations and send bond yields sharply higher. In short, the central bank finds itself in a difficult position whether it sells the securities or not. Either way a major ordeal awaits both the central bank and the bond market. 
Once this point is reached, the central bank will probably attempt to reduce the “real value” of liquidity in the market by sharply raising the statutory reserve ratio for commercial banks, a tactic frequently employed by the People’s Bank of China. 
But all these measures will have significant negative implications for the economic recovery. While QE will do little damage at a time when private loan demand is weak or nonexistent, like today, it requires the central bank to engage in aggressive tightening just when the private sector is beginning to recover." - source Nomura - Richard Koo.

Provided our "Buzz Lightyear" central bankers decide to use the escape capsule from their stricken spaceship, Richard Koo's commented:
"The magnitude of the increase would depend on how much liquidity had to be absorbed, but a major increase is possible given that both the economy and private loan demand will be recovering. 

The liquidity supplied to the market should be manageable if the rebound in private loan demand is weak, as it has been in Japan since 2006. But there could be negative implications for the economic recovery—including a sharp rise in long-term rates—if the central bank is forced to mop up these funds by selling long-term bonds." - source Nomura.

But then again a future rebound in private loan demand is questionable.

A sharp rise in long-term bonds would have indeed devastating effect on a country such as the United Kingdom and it reminded us what we wrote back in our June 2011 conversation "The UK conundrum - Stagflation redux and other housing/banking issues": "Bank of England will have to stay accommodative for longer than expected, given two thirds of UK mortgages depend on short term rates. This means that the UK households will continue to be battered by a declining real income, meaning an absolute decline in the standard of living. At the same time UK banks are piling on Gilts like US banks are piling on US Treasuries, not lending, shrinking their balance sheet but earning a nice spread in the process by borrowing close to zero and locking the spread on Government bonds."

So billionaires seeking safe haven for their wealth by investing in a luxury London home should be well advised to reconsider given gold has indeed presented higher returns from fixtures and fittings in the last decade than the property itself according to Knight Frank, as reported by Bloomberg:

"A typical so-called super-prime property in London’s Kensington neighborhood would have cost 24,000 ounces of gold a decade ago, compared with about 9,800 ounces now, Knight Frank said today in a report. “To visualize this, 9,800 ounces would be a cube about the size of a small footstool, admittedly a heavy one,” the London-based real estate broker said. The CHART OF THE DAY shows how the value of super-prime homes doubled in the past 10 years and climbed 14 percent since their previous peak in March 2008. In comparison, gold prices have surged more than fivefold in the last decade. Knight Frank defines super-prime as homes valued at 10 million pounds ($16 million) or more in central London neighborhoods such as Knightsbridge, Kensington, Mayfair and Belgravia." 
- source Bloomberg

Yes, every asset class has a cycle, and until the escape capsule is triggered, we are unlikely to see an end to the trend in surging gold prices, although the scarcity of prime real estate for sale have enabled prices to held their value better. You have a similar scarcity case in Paris, for prime real estate.

Some additional important points made by Richard Koo in his recent are the following:
"More liquidity = greater economic instability once QE ends
Those making a case for inflation targeting or GDP targeting never say how much liquidity will be needed. All they say is that the supply of liquidity should be increased until the targets are reached. 
But the actual outcome would be very different depending on whether achieving the targets required a 20% increase in liquidity or a 200% increase. 
If only a 20% increase were needed, it might be possible to drain excess liquidity in the course of normal market operations once the targets were reached. But absorbing a 200% increase in liquidity would require massive bond-selling operations that could have a major negative impact on interest rates and the economy. 
That the BOE was unable to turn the UK economy around with a 300% increase in the supply of liquidity suggests at the very least that 300% would not be enough. 
Moreover, economic activity supported by such a reckless increase in liquidity is likely to be unstable and to become even more so once the central bank began mopping up excess liquidity. 

QE may have net negative economic impact when viewed across life of program 
It has been argued that during a balance sheet recession, when the private sector is rushing to minimize debt, liquidity supplied by the central bank does not stimulate the economy. Once the private sector completes its balance sheet adjustments and is ready to borrow again, draining liquidity will serve to lift interest rates and depress the economy. 
This means if we examine the impact of QE across the life of the program, the negative impact of mopping-up operations may actually outweigh the positive impact of the initial easing. 
During a balance sheet recession, after all, the absence of private loan demand dulls the economy’s sensitivity to interest rates, which means its response is likely to be muted regardless of whether the central bank engages in QE. 
When the economy starts to recover, however, private loan demand would have also picked up by then, increasing the economy’s interest rate sensitivity. A rise in rates then would have a major negative impact. 
Viewed overall, it may be better under some circumstances not to supply excess liquidity at all during a balance sheet recession. This is because without it, there is no need to drain liquidity once the economy pulls out of the recession. 
The debate up to now has ignored the fact that rates will rise when liquidity is drained from the system, with potentially adverse consequences for the economy. Proponents of further accommodation continue to urge the central banks to leave QE in place until deflation has been vanquished. But they might come to a very different conclusion if they also considered the impact of the exit from QE. 

Time to reconsider quantitative easing 
So far, no QE program has been successful, even if we consider only the initial impact and ignore the exit process. The Japanese, US, and UK economies all remain in the doldrums. It is hard not to question the overall effectiveness of QE when we consider the fact that aggressive tightening (i.e., a draining of excess liquidity) awaits once the private sector finally starts looking forward again. 
Recently QE has been welcomed in some quarters for its ability to boost share prices or devalue the local currency. But there are pitfalls here as well. 
Share prices, for example, must ultimately be justified by earnings. But while equity prices have been rising in the US, the economy remains sluggish and the outlook for corporate profits is not particularly bright." - source Nomura.

Yes, share prices must ultimately be justified by earnings, but also by "inflation expectations" so "mind the gap" between consumer discretionary stocks and consumer staples stocks:

"As the CHART OF THE DAY illustrates, the S&P 500’s consumer-related industry groups increasingly mirrored each other after the index peaked at a record five years ago today. They were the period’s best performers among the 10 broadest industry gauges in the S&P 500. Makers of food, beverages, household products and other consumer staples set the pace by rising 29 percent. Companies most dependent on consumers’ discretionary income -- retailers, media companies, homebuilders, automakers -- ranked second with a 25 percent gain. The chart also shows financial stocks, whose 55 percent decline was the steepest among the 10 groups. Consumer-discretionary stocks may falter as a falling dollar spurs inflation, Leger wrote in an Oct. 5 report. The Dollar Index, a gauge of the U.S. currency’s value against the currencies of six major trading partners, has dropped as much as 6.1 percent from this year’s high on July 24." - source Bloomberg

Following what we commented in our previous conversation "Zemblanity" on what our Buzz Lightyear central bankers might find out in targeting the unemployment level (given the relationship between M2-velocity and the US labor participation rate over the years) is that the jobless rate can be a misleading gauge of labor market health as indicated by Bloomberg:

"One reason the Federal Reserve may be unable to reach consensus on an unemployment target: the jobless rate can be a misleading gauge of labor market health. While unemployment has fallen to 8.1 percent from 10 percent in 2009, the CHART OF THE DAY shows the percentage of people working, known as the employment-population ratio, has remained near its lows of the recession, suggesting limited progress toward a recovery in jobs. “In a better economy we would see an improvement in this data,” said Adolfo Laurenti, deputy chief economist at Mesirow Financial Inc. in Chicago. While the ratio has fallen as the baby boomer generation retires and because more students are returning to school “the tougher nut to crack is those people who are truly discouraged workers, who could be in the job market but are leaving.” The employment-population ratio climbed to a record high 64.7 percent in April of 2000 before falling as low as 58.2 percent in December 2009, the lowest level since 1983. A lack of labor-market improvement, even with the drop in the unemployment rate, prompted the Fed to begin a third round of asset purchases, or QE3, in which it’s buying $40 billion a month of mortgage-backed securities. While Fed policy makers have proposed continuing the Fed’s accommodative policies until the unemployment rate hits a certain level, as long as inflation remains contained, they haven’t been able to reach consensus on a jobless target. “We want to see the unemployment rate come down, but that’s not the only indicator, obviously, of labor market conditions,” Fed Chairman Ben S. Bernanke said in a Sept. 13 press conference. “The unemployment rate came down last month because participation fell; that’s not necessarily a sign of improvement.”" - source Bloomberg.

Once again, there is what you see and what you don't see in true Bastiat fashion.

To infinity...and beyond...we think.

Meanwhile Employment opportunities remain elusive for some Americans meaning that the poverty rate could remain high particularly with the looming risk of the fiscal cliff:

"The CHART OF THE DAY shows that the percentage of Americans living below the poverty line was little changed last year at 15 percent, or 46.2 million people. The poverty line is defined by the U.S. Census Bureau as those living on less than $11,702 per year, or $23,021 for a family of four. Food-stamp use climbed to a record 46.7 million people in June, according to the Department of Agriculture." - source Bloomberg

Unless the housing rebound in the US is genuine, and the private wealth effect translates to the real economy, we cannot see the long term benefits but mostly greater risks in maintaining for too long the QE toy in place.

 "I cannot help it - in spite of myself, infinity torments me." - Alfred de Musset

 Stay tuned!