Monetary Base

Much has ben written lately about the fact that the Federal Reserve is beginning to realize that they are caught in a "liquidity trap."  However, what exactly is a "liquidity trap?" And perhaps more importantly how did we end up in it - and how do we get out?

• Risk on assets supported by yesterday's speech by Bernanke, who said that highly accommodative policy needed for the foreseeable future and that current unemployment of 7.6%, if anything, overstates health of US labour market.
• ECB's Weidmann said that the ECB has not tied itself to the mast with forward guidance, which does not rule out rate hikes when inflationary pressures emerge.
• The BoJ kept their monetary policy unchanged and retained plan for JPY 60-70trl annual rise in monetary base.

On occasion of an address to economists at a conference in France, Bundesbank  president Jens Weidmann reminded the audience that 'the ECB cannot solve the crisis', because it is due to structural reasons and therefore requires structural reform. Weidmann rightly fears that governments will begin to postpone or even stop  their reform efforts now that the ECB has managed to calm markets down. In a Reuters article on the topic, a number of people are quoted remarking on ECB policy. What is so interesting about this is how far removed from reality general perceptions are when it comes to judging current central bank policies. In short, Weidmann wants to end the three card Monte, whereby commercial banks buy the bonds issued by governments because they don't have to put any capital aside for the purpose, which bonds they then can in turn pawn off to the central bank for refinancing purposes. Weidmann wants to see the connection between banks and sovereigns severed, a connection that has been fostered by governments over many centuries in order to enable them to spend more than they take in through tax revenues.

Barclays: "In the short run, such rebalancing and deleveraging point to further downside risks for both economic growth and asset prices, including the exchange rate. Based on an increasingly likely downside scenario, we think Chinese growth could experience a temporary ‘hard landing’, which we would define as quarterly growth dropping to 3% or below, within the next three years."

The volatility of recent weeks is but a mere small taste of the volatility in store for all markets in the coming months and years. The global debt crisis is likely to continue for the rest of the decade as politicians and central bankers have merely delayed the day of reckoning. They have ensured that when the day of reckoning comes it will be even more painful and costly then it would have been previously.

Kyle Bass covers three critical topics in this excellent in-depth interview before turning to a very wide-ranging and interesting Q&A session. The topics he focuses on are Central bank expansion (with a mind-numbing array of awe-full numbers to explain just where the $10 trillion of freshly created money has gone), Japan's near-term outlook ("the next 18 months in Japan will redefine the economic orthodoxy of the west"), and most importantly since, as he notes, "we are investing in things that are propped up and somewhat made up," the psychology of negative outcomes. The latter, Bass explains, is one of the most frequently discussed topics at his firm, as he points out that "denial" is extremely popular in the financial markets. Simply put, Bass explains, we do not want to admit that there is this serious (potentially perilous) outcome that disallows the world to continue on the way it has, and that is why so many people, whether self-preserving or self-dealing, miss all the warning signs and get this wrong - "it's really important to understand that people do not want to come to the [quantitatively correct but potentially catastrophic] conclusion; and that's why things are priced the way they are in the marketplace." Perhaps this sentence best sums up his realism and world view: "I would like to live in a world where it's all rainbows and unicorns and we can make Krugman the President - but intellectually it's simply dishonest."

While many impartial observers have been lamenting the death of Abenomics now that the Nikkei - essentially the only favorable indicator resulting from the coordinated and unprecedented action by the Japanese government and its less than independent central bank - has peaked and dropped 20% from the highs, Wall Street was largely mum on its Abenomics scorecard. This changed overnight following a scathing report by Goldman which slams Abenomics, it sorry current condition, and where it is headed, warning that unless the BOJ promptly implements a set of changes to how it manipulates markets as per Goldman's recommendations, the situation will get out of control fast. To wit: "Our conclusion is that the positive market reaction initially created by the policy has been almost completely undone. At the same time, a lack of credible forward guidance for policy duration means that five-year JGB yields have risen in comparison with before the easing started, and volatility has also increased. It will not be an easy task to completely rebuild confidence in the BOJ among overseas investors after it has been undermined, and the BOJ will not be able to easily pull out of its 2% price target after committing to it."

We have removed the levels to protect the innocent but which of these equity (or bond) markets would you be adding to today?

Wednesday may be the new Tuesday (which halted its relentless and statistically impossible streak of 20 out of 20 up DJIA days last week), if only in terms of the overnight no news stock futures ramp, which today is back with a vengeance. In a session that was devoid of any news, the e-Mini is up enough to practically erase all of yesterday's losses. Whether this is due to a relatively calm Nikkei trading session, to no further surge (or collapse) in the USDJPY, or to the 10 Year trading flat inside 2.20% is unclear. What is clear is that the bipolar market swings from extreme to extreme on speculation about the largely irrelevant topic of whether the Fed will taper (because if it does, it will be very promptly followed by an untapering once risk assets around the world implode.)

Overnight, following the disappointing BOJ announcement which contained none of the Goldman-expected "buy thesis" elements in it, things started going rapidly out of control, and culminated with the USDJPY plunging from 99 to under 96.50 as of minutes ago, which was the equivalent of a 2.3% jump in the Yen, the currency's biggest surge in over three years. Adding insult to injury was finance ministry official Eisuke Sakakibara who said that further weakening of yen "not likely" at the moment, that the currency will hover around 100 (or surge as the case may be) and that 2% inflation is "a dream." Bottom line, NKY225 futures have had one of their trademark 700 points swing days, and are back knocking on the 12-handle door. Once again, the muppets have been slain. Golf clap Goldman.

UPDATE: Nikkei futures now -500 from US day-session highs

In what must be quite a surprise to Goldman (as we discussed here), the BoJ has decided not to give in to the market's demands:

*BOJ REFRAINS FROM EXPANDING J-REIT, ETF PURCHASES (expected lifting of cap)
*BOJ LEAVES FUNDING TERMS UNCHANGED AFTER JGB YIELD VOLATILITY (expected extension from 1Y to 2Y)

The market's angry reaction... NKY -400 from US day-session highs, USDJPY gapped down 80 pips to 98.00, JGB Futs closed, JGBs unch. Full statement to follow:

Currency markets are anticipating the conclusion of the BOJ meeting on Tuesday. No changes are expected to the current policy scheme and asset purchase targets, but it is likely that the committee will introduce measures to try to stem JGB volatility.  Based on their recent record, it is unlikely they will succeed. Later in the week, the focal point will shift to the US where the monthly Treasury statement on Wednesday and retail sales data on Thursday will shed more light on how automatic federal spending cuts are affecting the broader economy.

The last couple of weeks have been very interesting. Remember that, certain regional differences aside, Japan has, for the past two-plus decades, been the global trendsetter in terms of macroeconomic deterioration and monetary policy. The West has been following Japan each step on the way – usually with a lag of about ten years or so, although it seems to be catching up of late. Now Japan is the first developed nation to go ‘all-in’, to implement a no-holds-barred money-printing regime to (supposedly) ‘stimulate’ the economy. We expect the West to follow soon. In fact, the UK is my prime candidate. Wait for Mr. Carney to start his new job and embrace ‘monetary activism’. Carnenomics anybody? But here is what is so interesting about recent events in Japan. At first, markets did exactly what the central bankers wanted them to do. They went up. But in May things took a remarkable and abrupt turn for the worse. In just eight trading days the Nikkei stock market index collapsed by 15%. And, importantly, all of this started with bonds selling off. Are markets beginning to realize that all these bubbles have to pop sometime and that sometime may as well be now? Are markets beginning to refuse to dance to the tune of the central bankers and their printing presses? Are central bankers losing control?

It is immeasurably easier to digitally create claims on real-world assets than it is to create real-world assets. The Fed can digitally print a trillion dollars at no cost, but that doesn't mean the money flows into the real economy. Once again we are compelled to ask: cui bono, to whose benefit?

Some of my first memories of television are of a series called The Rocky and Bullwinkle Show, which was a witty combination of animated cartoons about the exploits of the title characters, Rocket "Rocky" J. Squirrel and Bullwinkle J. Moose and their nemeses, two Pottsylvanian nogoodniks spies, Boris Badenov and Natasha Fatale. The show was filled with current event commentary, political and social satire. The show was also filled with commentary on economic and market conditions that resonated with the parents watching the show while the kids focused on the cartoons. Each show ended with the narrator describing the current cliffhanger with a pair of related titles, usually with a bad pun intended. So let's adapt some of my favorite Rocky and Bullwinkle episode titles to modern day; we might see that there are some political and economic challenges that are timeless, as it appears we have been doing the same thing over and over for decades and expecting different results.