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Matt King:"The Risk Is That Central Banks Created A Monster That Drives The Economy On The Way Down"
While most sellside "research" has traditionally been complete garbage, either meant to boost soft dollar revenues and build client goodwill by giving one-on-one "expert network" meetings with management, or a macro echo chamber of equity strategists all of whom are terrified to stray from the penguin, or is it lemming, flock (its only utility is to give insight into whatever the prevailing groupthink consensus is, allowing an easy opportunity to fade it) and desperate to be as optimistic as possible (there is little upside on Wall Street to be a pessimist or a realist) there are the occasional voices of profoundly insightful, "variant perception" views from within the big banks, almost exclusively from the credit, and rarely if ever equity, division. Names such as BofA's Michael Hartnett, DB's Jim Reid and Dominic Konstam, and of course, Citigroup's Matt King.
What makes these analysts unique is that they tell the truth as they see it, unpleasant as it may be (some reading between the lines may be required) even if it means breaching protocol and launching internal scandals over "client communication objectives." Two weeks ago, Dominic Konstam predicted, accurately, that the Fed's rate hike will be tantamount to policy error (as we showed by the market's response on Thursday and Friday). Then, taking it a step further, last Thursday we showed Hartnett's presentation how the Fed's rate hike has unleashed the next bear market.
Now, it's Matt King's turn, to explain wny the "risk is that central banks have now created a monster such that markets drive the economy, if not on the way up, then certainly on the way down."
From "Positive feedback loops" by Matt King
The broader narrative – in which central bank liquidity has pushed up asset prices without fostering a similar improvement in the underlying economy – is one we find the vast majority of [fixed income] investors are sympathetic to. The only question is on the timing: no one wants to get out too early.
This is one of the reasons we find the outlook for next year so difficult, and why there is so little agreement about it (even internally at Citi, never mind across the street). It depends less on fundamentals, and more on second-guessing what everyone else will do. Of course, markets are always to some extent like that, but self-reinforcing processes seem to have grown in importance in recent years. Rather than the economy driving markets, as is supposed to be the case, the risk is that central banks have now created a monster such that markets drive the economy, if not on the way up, then certainly on the way down.
Suppose, for example, that all does not go according to plan, and that the current squeeze higher in markets fades and even reverses. Perhaps oil price and EM weakness prove persistent, markets and the developed economies continue to prove more susceptible to these than they “ought” to, inflation breakevens fall, spreads widen and equities suffer even in the face of continuing share buybacks and record M&A. The scenario is far from unthinkable: indeed, it would simply be a continuation of everything we’ve seen in the past six months.
What we find really alarming in such a scenario is not only that the safety net might be a while in coming, but that we are increasingly doubtful of how much support it would provide, at least initially. Clearly the threshold for the Fed to reverse its hike, let alone do more QE or move to negative rates, is very high. And while the ECB should eventually do more, the bar to Draghi being able to spur the rest of the Governing Council to arms would now seem to have been raised.
Worse, though, the broad market reaction to central bank stimulus seems to be waning. In credit, and in Europe, this is not too bad. We do still think negative rates and QE retain a positive effect, even if it seems to be driving almost as much money into US fixed income as into European credit and equities. We are still divided on whether the right metric to plot against spread changes is just DM QE (in which case spreads ought to rally more, Figure 8), or total central bank liquidity including EMFX reserve changes (in which case spreads are much too tight, Figure 9).
The further away from the liquidity we look, the more precarious the picture becomes. In the US, and in equities, the fit excluding EM (Figure 10) is clearly less good than when it is included (Figure 11).
And when it comes to inflation expectations, central bank influence seems to have all but disappeared. The ECB has been able to push up inflation expectations only when the € has been weakening. This is completely the opposite of the longer-term relationship, in which a stronger euro was associated with higher inflation expectations (Figure 12). The Fed continues to project increases in inflation based on its models – just as it has done for the last six years – even as 5y5y market expectations have moved down to all-time lows.
Unfortunately for us in credit, this really seems to matter: there is a longstanding relationship between credit spreads and inflation expectations (Figure 13). Some of this will be the normal ebb and flow of the economic cycle, but it seems to go deeper than that. Most likely it is related to the process of credit creation4 and its stimulative effect in investment and growth. Spreads in $ and especially in € are tight relative to inflation expectations, presumably as yet another consequence of investors ignoring fundamental relationships and reaching for yield.
Like the Fed, then, we end up hoping their models are right – that consumer and services do finally respond to lower oil prices, that normal multipliers do kick in, that markets are able to shrug off EM and energy sector weakness, and that investors respond to this year’s disappointing returns not by licking their wounds, looking at higher $ deposit rates and resolving to save more, but by recognizing the improvement in value and doubling up.
We only wish we had as much confidence as Ms Yellen.... The financial system may be less levered, but that does not necessarily make it less fragile. With rate hikes as with mutual fund closures (and as with affairs), it is not necessarily the first one which makes people panic and rush for the exits. But nor is each successive one likely to be a help.
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The central banks created a monster when they took the world's currency off a gold standard. The monster has been driving ever since.
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Risk? Are you sure that wasn't the PLAN?
Fiat games. The best move is to not play.
the fed IS a monster. the only people they care about are bankers and billionaires. citi shouldn't even exist. end. the. fed.
Just compaire the PE levels between European stocks and American stocks and it becomes pretty clear which ones are the bigger shorts.
My god, how can anyone write another one of these "Gee, it has side-effects and we can't know what they will be" articles?
No kidding.
https://thinkpatriot.wordpress.com/2015/08/09/rules-for-flying-blind/
And, gee, maybe not just the Fed's affecting economics? Maybe it affects everything? And all the other laws and strutures also?
Yes, that is how we got here.
Love the photo of Goldman Sachs meeting with a muppet.
The Fed and Keynesian economics are a failed economic hypothesis. CBs were created only the provide the State with unlimited dollars for (also) failed socialism policies. The economic system is unsustainable and will collapse upon itself, and sooner than we think. The main problem is - and has been - too much (unproductive) debt. Debt matters. No really. “Late” or “early”, a quarter point rate hike at this point is completely irrelevant, just like the Fed and all the other CBs, and serve only to enrich their masters.
“You cannot spend your way out of recession or borrow your way out of debt.” - Daniel Hannan, Member of the European Parliament
"There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved." - Ludwig von Mises
“I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the Bank. ... You are a den of vipers and thieves.” - Andrew Jackson, 1834, on closing the Second Bank of the United States; (unabridged form, extended citation)
http://mogamboguru.com/Writings/2015/MGEN_011515.html
In Case Anybody Asks, We're Freaking Doomed
January 15, 2015 ?By: The Mogambo Guru
So hold onto your hats, because here it is. The fabulous and wonderful thing to do is the same thing that other people have always done to successfully escape the economic calamity, and have always done over the last 2,500 unbroken years full of dirtball governments borrowing themselves into bankruptcy: They bought gold and silver, the ultimate money and asset.
http://bawerk.net/2015/12/11/how-peak-debt-constrain-the-fed-from-moving...
How Peak Debt Constrain the Fed from Moving Rates Higher
by Eugen von Böhm-Bawerkon December 11, 2015
Since most added debt in the US economy, or the world for that matter, is consumptive in nature it adds nothing to the capital base and must therefore be repaid from legacy asset which were once put into productive usage. However, as the non-productive share increases relatively to the productive part, the system naturally comes under strain and will eventually reach debt saturation through capital consumption.
This process can be seen through different metrics, such as the fact that it takes ever more debt to “create” an extra unit of GDP, or the falling velocity of money; as more money get diverted toward unproductive debt servicing, less will be available for productive investments. That in turn, duly lowers GDP growth. Stated differently, lower velocity of money suggest the economy has reached debt saturation. If that’s the case, monetary policy becomes impotent. True; central bank balance sheet expansion may create the illusion that it isn’t, but that’s only because it helps to maintain funding for unproductive debt, which otherwise would be liquidated. This can only go on for so long though as avoiding consequences of reality is never a long term solution.
The fact that US money velocity has dropped to 1930s depression levels is indicative of how skewed, or mal-invested, the US capital structure has become; only liquidation of debt that cannot fund itself will cure this.
Several central banks across the globe have tried to escape from this predicament by raising rates without prior debt liquidation. They all had to reverse course as debt saturated economies cannot cope with higher rates without a proper clean up. Refusing to acknowledge, or failing to grasp, that unproductive debt cannot be funded forever, higher interest rates quickly diverted too much resources away from sustainable economic activity, putting pressure on growth and thus forcing central banks to cut rates soon after they tried to raise them. When the pool of real savings are not there to support the economic structure, all monetary policy can do is to temporary sustain the unsustainable. However, as times goes by, and capital consumption continues, economic stagnation occurs even at ZIRP, NIRP and QE as all these tools can do is to redistribute capital.
http://www.peakprosperity.com/podcast/86788/lacy-hunt-world-economys-ter...
Lacy Hunt: The World Economy's Terminal Case of Debt Sclerosis
In danger of dying from too much debt
by Adam Taggart
Sunday, August 24, 2014, 11:54 AM
Dr. Lacy Hunt: That's a very well taken point. We're taking on some productive type of debt. We're investing in oil and gas exploration, we have some investment in plant equipment, new technologies; we have some infrastructure expenditures that we're financing with debt. The problem is that the consumptive type debt, the speculative type debt, is three or four times greater than the debt that we know will generate a cash stream to repay principal and interest. The difficulty that we have here is exactly the problem that occurred during the 1920s. We lived far beyond our means; we took on a lot of debt. It was the extreme over-indebtedness which set up the 1930s. It was the extreme over-indebtedness of Japan during the 1970s and 1980s that led to their panic year in 1989. It's extreme over-indebtedness in the U.S. in the first part of this century, and in Europe as well, that set up their difficulties. Once you go through this period of over accumulation of debt or under saving, you can look at it in either terms, then the negative outlook is basically baked in the cake. That's really where we are and we don't have a will to get out of it. We have to rely on tough fiscal policy decisions and strong political leadership, and that's just not an option in the U.S., Japan, Europe or anywhere.
We cannot rely on more credit, more debt to try to restore the economy. The policy makers here are in a bit of a dilemma. We can't move forward on fiscal policy, the decisions are too tough, too onerous for too many people. No one's willing to have shared sacrifice. So we rely on monetary policy with all of its flaws and its negative consequences. And so the economy, in a very important structural sense, is fundamentally weaker now than we were a decade ago, or two decades ago, or three decades ago.
Well I think the evidence is that the quantitative easing failed, both one, two and three. The ten and 30 year yields were higher when the phase down of quantitative three was announced than before quantitative one began. And the academic studies, which are impressive, indicate that the large scale asset purchases actually had a counterproductive effect.
Here's the difficulty, and I think it goes back to over reliance on Keynesian economics. Keynes, before he died in 1946, developed a concept of an underemployment equilibrium in which the U.S. economy would remain mired with excessive unemployment and this was baked into the cake. Unless the government ran large deficits when World War II ended, and that was the only way out. Now remember that Keynes' interpretation of the 1930s was that there was insufficiency of aggregate demand; there was not enough of consumer spending. I think that Keynes was correct in arguing that the Great Depression was due to an insufficiency of demand. But where Keynes failed is that he did not understand that the insufficiency of demand in the 1930s was baked in the cake once we had taken on the excessive debt of the 1920s. What the modern [neo] Keynesians do not understand is that the underperformance that we are experiencing today was baked into the cake by the big run-up in debt in the 20 years leading up to the 2008, possibly the 30 years leading up to 2008.
…we have not corrected the balance sheet imbalances; and as long as they persist, we are stuck in this situation.
The real economy never did support this market. To say that the market may drive the economy on the way down is disingenous at best. Matt king gets paid to write froth. So who cares?
Central Banks are dumping reserves by the hundreds of billions of $ driving the world economy into depression.
http://www.plata.com.mx/Mplata/articulos/articlesFilt.asp?fiidarticulo=279
<-- US Fed , the central bank in chief
Head of Gold & Feet of Clay