Archive for September, 2011
Among the many spectres raised to justify the current bear market, one of the most persistent is that of deflation. Some central banks, too, have referred to this unspeakable terror in an effort to legitimize their more exotic recent policy action. We had a look at the dove argument on inflation three weeks ago and challenged its tenets then. When it comes to outright deflation, however, we can also invoke the experience of Japan and ask the question: how close are other developed nations to a similar state?
To recap: Japan’s economy has been through hell since the collapse of the 1980s economic and investment boom. The stock market crashed in 1990, growth began to slow, and the Bank of Japan cut rates accordingly. The yen, however, was allowed to appreciate by over 50% on a trade weighted basis at the same time, more than compensating for this effect and ensuring a recession which saw growth move sideways for two years. This accelerated the pace of decline in the property market, which contributed to a major financial crisis.
Another period of massive yen appreciation followed in the wake of the collapse of the Asian tiger economies, which together with the collapse of the TMT boom saw the level of Japanese real GDP move sideways for five years this time (1997-2002). A period of respite followed – until the latest banking crisis, stock market crash, and now the earthquake of this year which has plunged the economy into recession yet again: the fifth episode of negative real year-on-year GDP growth in twenty years, which has seen the economy contract to its level of six years ago. Over the last two decades as a whole, real growth has averaged a barely perceptible annual rate of 0.7%.
Even with that cataclysmic, catatonic performance, persistent and significant price deflation has only occurred alongside the more savage contractions in growth. The nationwide CPI moved about 4% lower peak to trough after the 1997 collapse, and remained pretty stable thereafter until the credit crunch (so delivering annual inflation of zero, rather than deflation per se). This time it sank about 2% from end-2007 to end-09, since when it has again remained flat.
A diehard bear might well argue that a similar experience awaits the terminally doomed economies of the US and Europe. So rather than argue, let’s look at what this contractive, deflationary backdrop has meant for Japanese asset prices.
Interest rates have averaged 0.25% over the last ten years, decimating returns to cash. 10 year bond yields have averaged 1.4% over the same period (and traded in a range of about 1-2% since 1997). Equities have been rangebound too, though it is worth noting that the Nikkei rose to a peak 132% above its post-dotcom low in 2007, while the S&P 500 managed a mere 90% in comparison.
All of which suggests to this blog that cash rates and bond yields are already pricing in the Japanese experience across most of the developed world. Equity markets are the exception: while they are close to their 20-year lows, their valuations are way below Japan’s. (In the middle years of the last decade, the p/e on the Nikkei drifted around 30-40x – an earnings yield of 2.5-3.5%, which looks low but was generous relative to other classes of asset).
In other words, asset prices at present suggest the fear of something even worse than Japan’s lost decades. It’s arguable whether such a reality could possibly exist. But you can’t argue that it’s a properly bearish view.
Confronted with a debt-ridden, downgraded economy, the central bank is divided. In the face of sub-trend figures for growth, a minority insist on worrying about inflation. The majority prevail, however, and vote through a plan to intervene in bond markets in one last, desperate throw of the dice.
Yes, it was business as usual at the Federal Reserve this week. And not for the first time, this blog feels a little sorry (but only a little) for the beleaguered leaders of the central bank.
First of all, it is wrong to dismiss this latest intervention as ineffectual. The point is not that the Fed has chosen to maintain the size of its bond buying programme rather than increase it, as some had expected. The point is that by buying – or signalling that it will buy – bonds of longer maturities, it can influence mortgage rates. Unlike the UK, where the mortgage market is anchored firmly to the central bank’s policy rate, US mortgages tend to be sold at fixed rates for terms of up to 30 years. Allowing for prepayment behaviour and various other mechanics of the American mortgage market, this means that the key reference rate is not the central bank rate but the ten year swap rate, over which the Fed usually exerts no control.
Following the announcement of Operation Twist, however, that rate has fallen 20bp. If it holds its current level of a little under 2%, the average US mortgage rate – last reported by Freddie Mac at 4.7% for July – should be expected to fall to around 4.1%. This is well below the 4.5% reached last November, and should therefore trigger a new round of mortgage refinancings, putting extra money in the pockets of existing mortgage borrowers.
Ben Bernanke knows all about this sort of thing, having written more than one landmark essay on the transmission mechanisms of monetary policy. His switch idea should have been an elegant solution: cut the mortgage rate without “printing more money” by adding to the Fed’s aggregate holdings of US bonds, thus stimulating demand while appeasing the (few, bedraggled) inflation hawks.
Unfortunately for Bernanke et al, any understanding or appreciation the world might have shown for this subtly choreographed monetary ballet was swamped by panic over the Fed’s accompanying programme notes. Talking of “significant downside risks” to the US economy and “strains” in financial markets, they were doubtless supposed to provide only the necessary context to the spectacle of the policy response. Sadly for all of us, they stole the show. Bernanke and others should consider how far the wealth effect of the 6% fall in the S&P 500 that has ensued will have taken the shine off any improvement in mortgage rates. And that’s before we consider the monetary impact of the 2% strengthening in the trade weighted dollar as the world stampeded for quality. (Who knows? Perhaps some future Fed Chairman out there will write a landmark essay on the subject.)
It looks as though those tedious old hawks were right, and that the Fed would have been better off without its cunning little bond market ballet. Let’s hope it’s a one off: if they’re right about inflation too, then we’re in serious trouble.
To be fair, equity markets had been creeping higher all week and were already up on the day. Bonds had nudged lower. Colour was beginning to return to the markets’ cheeks. But the announcement yesterday that the ECB and the Fed (and the Bank of England, Bank of Japan and Swiss National Bank) were joining forces to prevent a squeeze on dollar funding to eurozone banks turned cautious hope into outright relief. On top of the Franco-German statement of continued support for Greece on Wednesday, it looked as though the cavalry were riding to the rescue at last.
As it happens, of course, the cavalry joined the fray a while ago. Europe’s problems – and fears for the global economy at large – have dominated the political and financial agenda for some considerable time. If the world’s traders, journalists, economists etc. can see something, so can its leaders. The banking crisis, and other major crises before it, occurred because too many people had taken their eye off the ball and believed all was well. In fact, most participants in and observers of the doomed subprime and structured credit markets thought that they and their products were the cat’s whiskers and that anyone who disagreed was an idiot.
Such is the way of booms and bubbles; such has hardly been the way with Greece and its attendant concerns.
And yet there is one corner of the financial world where unbridled optimism remains the order of the day.
According to a report out yesterday from a firm of metals analysts, gold is going to hit $2,000 an ounce this year on the back of record investor demand. “Where else do you park your money?”, asked one of its authors.
Nonsense, says a strategist at SocGen. A miserly two thousand bucks an ounce? The fair value of gold is actually over ten. (This insight was based on dividing the size of US gold reserves into a monetary aggregate. As well as the concept one could also criticise the particular aggregate used as it happens, but life is short.)
This blog has long been sceptical of gold. A hedge against a falling dollar that also went up as the greenback rose; a hedge against inflation that continued to rally as annual CPI turned negative – heads you won, tails you couldn’t lose. Even the language – “park your money” – reveals a psychology insouciant in the face of the exceptionally high volatility associated with investment in commodities. (Rather than leaving your car in a nice car park, trading metals is more like strapping it to a giant rollercoaster.)
And of course, this blog has been wrong: gold has continued to rise – and rise, nearing the $2,000-per-ounce territory it last (briefly) held in early 1980 (in today’s dollars). “Just look at the money I’ve made,” a critic of the bear view might reasonably reply. “You’re an idiot.”
Such is the way of things. But should demand wane, where will support come from? The world needs a financial system. We still need banks, and credit. That’s why the cavalry have appeared: there are some battles that have to be won.
Who needs gold?
ECB head Jean-Claude Trichet’s press conference yesterday signalled a more dovish stance on prices. His view now is that risks to inflation in the eurozone have abated in light of the renewed uncertainty over growth and are broadly balanced. While noting that monetary policy remains accommodative in the euro area, his remarks clearly indicate a cessation of the policy tightening that began in the spring. Like the Fed, the Bank of England and others, the ECB is now on hold.
This brings M Trichet into line with a powerful consensus that inflation is the least of the world’s problems at present. The argument runs like this. Over most of the developed world, growth is sluggish and unemployment high. With consumer demand and the bargaining power of labour both weak, there is accordingly no domestic inflationary pressure. Such price rises as we have seen are the result of commodity price increases which have forced up input costs. As growth fears have intensified, commodity prices have come off the boil; therefore, the input cost effect will fall away and inflation will subside.
Economic recoveries, however, tend to be bumpy. The slowdown in growth rates observed for certain economies this year could turn out to be no more than a pause for breath. Commodity weakness could turn out to be equally short lived. How far could commodity prices go? As measured by the S&P GSCI spot index they would have to rise another 33% simply to regain their April 2008 peak (and that’s in nominal terms).
There are those who would simply laugh this possibility out of court. With equity markets bumping along the bottom, bonds near record highs and oil off 2% on the day at time of writing it certainly feels like an eccentric concern. But it is a fact that rates of inflation have in many cases already risen to levels with which policymakers would have been uncomfortable in the pre-crisis past.
It is also a fact that price behaviour doesn’t turn on a dime. Estimates of the time it takes for monetary policy to feed through to prices vary, but a lag of 18-24 months is what is generally assumed. Last December, Fed Chairman Bernanke boasted that should the inflationary outlook deteriorate, he could raise interest rates in 15 minutes if he had to. The problem is, prices could continue to gallop into the distance for more than 15 months thereafter.
The doves are certainly in the ascendant for now, and understandably so. But their view has become absolutely predominant and the policy bias completely one-sided. If the present complacency over prices turns out to have been mistaken their retreat could prove dramatic.