Monetary Policy

The world's largest hedge fund is not as sanguine about the hope that remains in the markets today. The firm's founder, Ray Dalio, who has written extensively on the good, bad, and ugly of deleveragings, sounds a rather concerned note in his latest quarterly letter to investors as the "developed world remains mired in the deleveraging phase of the long-term debt cycle" and has spread to the emerging world "through diminished capital flows which have weakened their growth rates and undermined asset prices". Between China, Europe, and the US, which he discusses in detail, he sees the lack of global private sector credit creation leaving the world's economies highly reliant on government support through monetary and fiscal stimulation. The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country's decline tends to reinforce another's, making a self-reinforcing global decline more likely and a reversal more difficult to produce. After discounting a relatively imminent return to normalcy in early 2011, markets are now pricing in a meaningful deleveraging for an extended period of time, including negative real earnings growth, negative real yields, high defaults and sustained lower levels of commodity prices. Lastly he believes the common-wisdom - that the Germans and the ECB will save the day - is misplaced.

There was yet another European Union summit at the end of June, which (like all the others) was little more than bluff. Read the official communiqué and you will discover that there were some fine words and intentions, but not a lot actually happened. The big news in this is the implication the ECB will, in time, be able to stand behind the Eurozone banks because it will accept responsibility for them. This is probably why the markets rallied on the announcement, but it turned out to be another dead cat lacking the elastic potential energy necessary to bounce. Meanwhile, Germany, meant to be the back-stop for this lunacy, is losing patience. It has become clear that the agreements that arose out of the June summit were not agreements at all. The questions arises:  How can the Eurozone stay together, and if not, how quickly is it likely to start disintegrating? And where does the exchange rate for the euro fit in all this?

From UBS: "We think that a creditor nation is less at risk of hyperinflation than a debtor nation, as a debtor nation relies not only on the confidence of domestic creditors, but also of foreign creditors. We therefore think that the hyperinflation risk to global investors is largest in the US and the UK. The more the fiscal situation deteriorates and the more central banks debase their currencies, the higher the risk of a loss of confidence in the future purchasing power of money. Indicators to watch in order to determine the risk of hyperinflation therefore pertain to the fiscal situation and monetary policy stance in high-deficit countries. Note that current government deficits and the current size of central bank balance sheets are not sufficient to indicate the sustainability of the fiscal or monetary policy stance and thus, the risk of hyperinflation. The fiscal situation can worsen without affecting the current fiscal deficit, for example when governments assume contingent liabilities of the banking system or when the economic outlook worsens unexpectedly. Similarly, the monetary policy stance can expand without affecting the size of the central bank balance sheet. This happens for example when central banks lower collateral requirements or monetary policy rates, in particular the interest rate paid on reserves deposited with the central bank. A significant deterioration of the fiscal situation or a significant expansion of the monetary policy stance in the large-deficit countries could lead us to increase the probability we assign to the risk of hyperinflation."

There is a strange delayed reaction between the initial exposure of weakness in the financial system and the public’s realization of the truth, sort of like Wile E. Coyote dashing off a cliff in the cartoons only to continue running in mid-air above the abyss below.  It is a testament to the fact that beyond the math, there is an undeniable power of psychology in our economy.  The investment world naively believes it can fly, even with the weight of endless debt around its ankles, and for a very short time, that pure delirious oblivious belief sustains the markets.  Eventually, though, gravity always triumphs over fantasy…

As Messers Frank and Paul take on the Bernank this morning, we reflect on the four easing options that the illustrious fed-head laid out in a statement-of-the-obvious that still managed to get the algos ripping. As Goldman notes, his prepared remarks were terse (and lacking in 'easing options' discussion) - cautious on his outlook, concerned at Europe, and fearful of the 'fiscal cliff' - but his response in the Q&A were a little more revealing as he laid out his choices: asset purchases, discount window lending programs, changes in communication about the likely path of rates or the Fed balance sheet, or a cut in the interest rate on excess reserves. We discuss each below but note, just as Goldman believes, that while we think that a modest easing step is a strong possibility at the August or September meeting, we suspect that a large move is more likely to come after the election or in early 2013 (and not before), barring a very rapid further deterioration in the already-cautious near term Fed economic outlook (which we assume implicitly brings the threat of deflation).

European equities are trading in minor positive territory on light volume and a light economic calendar with the exception of the IBEX and the FTSE MIB which are down 0.3% and 0.4% respectively as US participants begin to come to their desks. Headline employment data from the UK was for the most part in-line with expectations, though the jobless claims change for June showed a 6.1K increase compared with the 5.0K expected, with downward revisions to May’s figures. The BoE minutes showed the July increase in APF was not unanimous at 7-2, and a GBP 75bln increase was also discussed, and that should the additional easing measures not work, a further rate cut would be examined. The final comment caused a spike to the upside in the short Sterling strip of 6 ticks, Gilt futures rose to make highs of 121.78, and GBP/USD to slide back below 1.5600, though the pair has since come off its lows and trades back above this level.

It may be blasphemy but we ask "Is a Eurobond necessary?" UBS' Paul Donovan suggests the short answer to this question is “no”. The long answer is “no, of course not, not like this”. The Euro area seems to have drifted into something of a fiscal backwater with the debate over Eurobonds. German Chancellor Merkel has rather melodramatically declared that Eurobonds will not be an option as long as she lives. As Donovan notes, European politicians go back and forth over the merits, necessity, and preconditions for Eurobonds. He sees this as "a waste of time". Eurobonds are not a necessary condition for the survival of the Euro, even though (in our view) fiscal union in some form is a necessary condition. The Eurobond debate is diverting valuable political and economic resource into what is at best an irrelevance, and at worst may actually undermine the stability of the Euro area.

Ben Bernanke will deliver the semiannual report on monetary policy to the Senate Banking Committee Tuesday. The market is hoping and praying that the Chairsatan will make it rain. He won't. In fact, as explained earlier, it is likely that Ben will say absolutely nothing of significance today and in a world in which only the H.4.1 matters, this is not going to be taken well by the market. Of course, if Benny does crack and promises to push the S&P to 1450 just in time for the re-election, all bets are off.

And so it begins...Last Friday the Spanish government published a proposal to cut government expenditure and raise taxes to reduce the fiscal deficit by 56.4billion euros by 2015.  I have outlined why austerity will not work in Europe, but it looks like this is a lesson Europeans will have to learn for themselves--for a second time.  The writing is on the wall in Ireland, who ailed in the same ways that Spain is currently ailing, but what Lord Merkel wants, Lord Merkel gets.  The immediate malaise from these austerity measures will be large-scale social unrest, which is already being planned by many of the 50% of the country's unemployed young people.  Regardless of one's stance on the economic merit of austerity, what is indisputable is that riots are real and riots do not end well.  With nothing to lose, this round of Spanish austerity protesting has the potential to end in catastrophe.

When it comes to insight into what is on Ben Bernanke, nobody is quite as capable as the firm that runs not only the NY Fed, but virtually every other central bank in the world: Goldman Sachs. Below we present Jan Hatzius' thoughts on what to expect when Bernanke takes the stand at 10 am today when he delivers the first day of his semi-annual Humphrey Hawkins presentation to Congress. Many expect him to hint at more QE, and lately a tempest in a teapot (to use the parlance of our times) has erupted over the possibility that the Fed will lower IOER to 0 or even negative. Here is what Goldman has to say about that: "we do not expect an IOER cut at this time." In fact, Goldman is rather skeptical Bernanke will hit at much if anything, especially with bond yields already at record lows: after all, how much more frontrunning of the Fed's bond or MBS purchases is there? Instead look for much more grilling on the Fed's role in Lieborgate: congress is now realizing it is woefully behind its UK political cousins when it comes to reaping points from years of global Libor manipulation. More importantly, Maxine et al have finally finished all those "Libor for absolute corrupt idiots" books they ordered almost a month ago so they are truly prepared.

The reason for the ramp in risk as attributed by various buyside desks as to what recently has become the trademark of more hope, prayer and magic from Jefferies' (yes, Jefferies is driving the market for once, who wouldathunk it) David "SPOOS" Zervos, whose latest note that the Fed will follow the ECB and cut its overnight excess reserves rate to -0.25% has picked up some traction, and is causing a modest rise in risk markets. Here is the problem: the Fed will NOT do this, and certainly will not do this for months and months as not only would it destroy the US money market, general colalteral, unsecured and virtually every other overnight market instantaneously (and not even Ben is that dumb to trade a few trillion in private sector overnight funding for 10% in the S&P), but even as Zervos says this is nothing short of a thought experiment in what may happen: "Whether it happens or not is not the point. The issue is that we are not priced for it AT ALL." Correct David: they are unprepared because it will not happen. The Fed will do much more LSAP, and even that other flow-based lunacy, NGDP targeting, before it decides to blow up overnight markets (not to mention destroy the entire Primary Dealer risk analytics system all of which is based on positive flow from Reserves). Because if the Fed telegraphs it is ending the inflows from reserves experiment started 3 years ago, we better be having 4% GDP growth. Reality check: we have 1.1% Q2 annualized GDP. Finally, that whole ECB experiment with negative Deposit Rates led to... absolutely nothing... correction: it led to yet another plunge in Spanish and Italian yields: something the Fed is quite aware of.

Via Goldman, here are the key economic events to look forward to in the coming relatively quiet week. And out of DB, we get a list of the key PIIGS bond auctions and bailout events in the immediate and near-term future.

The market's hopes and dreams for the next LSAP remain high. As gold inches higher, tail-risks priced out (expectations for extreme FX moves are considerably lower than sentiment would suggest), and US equity vol expectations (and put skews) are crushed; the equity market clearly remains 'at a premium' in its notional indices given what is sheer lunacy in earnings expectations going forward. The question every investor should be asking is not when QE or even if QE, but so-what-QE? As Credit Suisse notes, given the deterioration in US economic activity (and the extension of Operation Twist) the FOMC will probably wait until its September meeting (and remember the trigger for further pure QE is a long way off for now). The most critical question remains, will additional QE work? After all, few would argue that US interest rates are too high or that banks in the US need still more excess reserves. Two things stand out in their analysis of how QE is supposed to work (transmission mechanisms) and its results to date: QE1 was more effective than QE2, and it's easier to find QE's effect on Treasury yields than on real economic performance. Perhaps more concerning is that the potential negative effects of such unconventional monetary policy has received little attention (aside from at fringe blogs here and here).

Even though the policy mix is extraordinarily stimulating, developed-world economies just cannot embark on a virtuous circle of recovery. Worse still, as Pictet points out in this excellent brief, governments, whose finances have been bled dry, are powerless to boost demand. This all suggests, they note, that Keynesian policies have failed. With no credit to dispense, State-administered Keynesianism is, in effect, bankrupt as government spending levers can no longer be activated. The implications are plain for all to see: once governments apply a brake to public spending, growth slows considerably. Economies of the developed world have become addicts, ‘hooked’ on government spending. A fresh approach to economic policy is needed. But policymakers will need to be both bold and brave as excess lending will always and inevitably lead to artificially-driven economic growth as it breaks the link between the cycles of innovation and economic growth. At a time when capitalism is being accused of the most reprehensible wrongdoings, policymakers will need to display great courage to promote the virtues of entrepreneurship and business.

As Euro area policymakers continue to ‘muddle through’ the crisis, everyone's favorite FX Strategist - Goldman's Thomas Stolper, summarizes the decline in the EUR so far as due to slower growth and easier monetary policy, together with growing EUR short positions. Of course, the root cause of both developments is the political crisis in the Euro area. The uncertainty about the stability of the institutional framework of the Euro area forces front-loaded fiscal tightening, which in turn damages growth. In response, the ECB eased policy more than expected, while the Fed, did not ease as much or as early as many projected. Despite today's ecstacy in EURUSD, Stolper believes the EUR is unlikely to strengthen materially as long as this situation persists especially as the potential for the ‘fiscal risk premium’ to rise on the back of daily headlines that are dominated by disagreement and dispute remains. In an effort to clarify his thinking, Stolper identifies eight key issues that will determine the outlook for the Euro. Most of them relate to the Euro area crisis. The most interesting ones are possibly the timing of a recovery in the periphery, the ability of France and Germany to develop a common vision for further integration, and the evolution of fiscal policies in major economies outside the Euro area. He concludes that the risks in the near term remain substantial.