Wednesday, 10 October 2012

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!

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