The paradox of monetary policy: reducing IRs below the lower bound is a seriously flawed policy

What we are seeing is a misconstrued extenuation of policy applied to a once rising frame, and indeed it is plausible that we have been following a path of unconventional monetary policy for a much longer time.   What we thought were monetary shocks on the way up were merely reactions to divergences occasioned by overly aggressive expansion of money supply. 

In its recent World Economic Review the IMF nicely, if not completely, summarised many of the world’s economic issues.  One thing clearly communicated was that global economic growth is both slowing down and in transition and that this must have consequences for monetary policy. 

The world has become increasingly dependent on debt (principally new money supply growth originated debt and asset focussed MS’s velocity dynamic within the asset sphere) to finance consumption, investment (and increasingly to a much greater extent, financial leverage), and while this was fine as long as growth barrelled along, incomes rose and populations continued to grow, it all started to go pear shaped as the engine started to wobble.  Lower interest rates designed to encourage consumption and investment, and loan growth financing the two, did just that and more so: in fact one of the consequences of lower interest rates was to increase the asset focus of money supply growth; a secondary consequence was to provide a source of additional expenditure (US especially) via home equity lines of credit drawing off rising asset values, at least until 2007. 

An inversion of many of the factors that had at one time driven growth were reversing at precisely the same time that debt and debt financed consumption expenditure was rising (1990s) and this is well evidenced in Japan.  Well we all know what happened next, ultimately the 2007/2009 financial crisis, but also a string of financial wobbles along the way. 

Slowing growth and rising debt could not coexist within the rising interest rate environment of the mid 2000s and hence we arrived at 2007 and onwards.  In truth, declines in interest rates and growth rates, combined with rising debt, on a global basis, have created a veritable choke hold and “post much greater QE”, one with increasing volatility and sensitivity to changes in monetary flows.  The overall complex whole is full of transitional issues, and these are discussed at length in many previous posts: understanding these various strands impacting demand and supply, loan growth and structural imbalances both domestically and globally is important if you are to be able to translate the many competing nuanced arguments being expounded both for and against unconventional monetary and dare I say it fiscal policy.

That said, we have remained remarkably transfixed on the one size fits all monetary policy to drive growth forward, hoping that low interest rates will spur borrowing for consumption and investment and somewhat erroneously hoping that those with cash will spend it.  Ultimately we are hoping that QE will drive the animal spirits and re awake the growth of good times past.

In the typical economic model with its rationale agent, the agent would be focussed on maximising short and long term consumption/saving from a given income.  Changing interest rates and inflation assumptions would immediately impact key consumption/saving decisions, and so the balance of expenditure between consumption and investment/savings.  But agents on average are neither wholly rationale nor are resources (income and wealth) equitably spread.  Moreover, the resources available for consumption and expenditure are not necessarily constrained to income/capital, but extend to new bank originated loans. 

Indeed the accumulation of imperfect decisions and growing imbalances as well as emergent dynamics (deflating/inflating economic frames and the changes they bring to key economic relationships) can constrain the impact of IRs and money supply on natural adjustment mechanisms.  In other words simple models ignore the actual balance of factors and the impairment of those factors in terms of their sensitivity to policy tools such as interest rates.  

The problem is that as growth slows, the amount of new money supply growth (loan or QE originated) should also decelerate, something which has not really happened.   In a slowing growth environment (one that may be characterised by a declining economic frame: population growth, demographics, productivity, increasing income inequality) we become ever more dependent on a market’s balance and allocational efficiency, that is the relationship between productive capacity/asset and debt values to changes in supply and demand dynamics and the distribution of income/wealth needed to maintain an appropriate balance of consumption and investment in a frame as it transitions.

What we have been doing is increasing money supply growth as growth falters and falls, all the while accentuating many of the imbalances hindering necessary frame transitions.  This has raised debt/equity values as GDP and income growth slows, increasing the sensitivity of the markets and the financial system to growth and changes in growth and raising the latent size of associated future demand shocks.   The solution has been to continually lower interest rates and when interest rates have been as low as they can go to swap debt assets for newly created central bank money.  We now appear to be about to extend this sequence, by reducing interest rates below the lower bound.

What we appear to have confused are the one time solutions to recessions occasioned by monetary tightening, that is to reduce interest rates as activity declines, in expanding frames, to applying the same medicine for a declining growth/deflating frames.  The argument being that the recessions were caused by monetary shocks impacting demand and hence any demand deficiency can be dealt with by monetary stimulus: well, of course, monetary stimulus can of course influence demand, but not without creating imbalances between assets and their value and the frame and capacity, at times, and the growth rate of the frame.    

In short, we do not need more money supply growth as a frame deflates, but an adjustment of the capacity and related capital (debt/equity values) so as to minimise divergences between growth and capital, including debt and its many forms, and hence to minimise shocks to the financial and the economic re maintaining balance between the two.

What we are seeing is a misconstrued extenuation of policy applied to a rising frame, and indeed it is plausible that we have been following a path of unconventional monetary policy for a much longer time.   What we thought were monetary shocks on the way up were merely reactions to divergences occasioned by overly aggressive expansion of money supply. 

I personally feel that arguments to reduce interest rates below the zero bound are seriously flawed, but flaws themselves ingrained into the body economic and financial for too long for many to be able to differentiate the reality of the trajectory. 

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US employment figures in the context of consumer credit and inventories.

The US economy is no ordinary cake in the oven and the release of the latest employment numbers do nothing to disprove this analogy.   Global economic growth is continuing to slow as evidenced by trade numbers, manufacturing data and a host of PMIs.  The direction of cause in this most recent of trends has been from key emerging economic regions.  The direction of cause is one for concern given the importance of the development of consumer markets in emerging economies to aging and slowing developed economies.  A slowdown in emerging market growth is important for asset markets and financial stability (loan servicing and financing) given that asset values and debt financing are heavily predicated on a discounted future.  The possible impact on global growth and financial stability of this reversion of cause and hence flows may well prove to be of significance.

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A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

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I am not a fan of outsized monetary accommodation in a declining growth frame…but what can you do?

Irrespective, deflation is not the issue, but slowing growth within a complex frame over burdened with financial excess and key structural imbalances. 

A recent speech by Andy Haldane has kept the interest rate/zero lower bound debate “bubbling”.   In this speech, “How Low Can You Go”, Haldane broached the issue of monetary policy in the event of another demand shock.  He is quite right to do so since monetary policy would have little room for manoeuvre with interest rates only a scuff mark away from 0%.  His musings suggested getting rid of cash and bringing in negative rates.

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The China Crisis may be signalling the end of the “rationale” for zero lower bound asset price support.

I do not think that anyone really suspects that we are at the start of an aggressive tightening of interest rates by the Federal Reserve.   A 1/4 point increase in rates would be unlikely to do anything much to growth even at today’s relatively low rate of GDP growth.

In truth, the problems with GDP are not necessarily to do with interest rate costs in the sense that growth is not being held back by the cost of money.  Today’s low interest rates are here pretty much as part of an asset price support operation, as is QE.  The reason why they have remained so low, post 2008 (in the US at least), is because of the increasing importance of asset market stability (given debt levels) to the financial system in a low growth, post financial shock, environment.  

As such, interest rate and monetary policy have been supporting the asset price/GDP disconnect post the financial crisis on the assumption that the shock to growth was temporary and transitory.  Unfortunately the impact of the financial crisis on growth was neither, partly because debt levels were higher than could be supported by GDP growth pre crisis, but also because underlying growth, ex monetary/debt stimulus, was declining, for a number of reasons.

Post crisis, what we have had globally is an increase in debt levels, while pre crisis growth levels have not recovered.  The temporary asset price support operation has lasted longer than expected and has facilitated a further increase in asset focussed MS (increasing instability of the financial system), asset prices and asset focussed debt.

Do interest rates need to rise to prevent inflation surging ahead in the US economy? 

Wage growth remains weak and there does not appear to be material capacity constraints at any level.  The only real concern is rising consumer credit: consumer credit relative to income growth, especially non revolving credit, has been rising at historically high levels post crisis.  This hearkens back to fundamental issues in the structure and distribution of key growth drivers that are independent of interest rate factors. 

Low interest rates/QE have enabled further divergence between assets and debt and GDP and income growth, something that I do not believe was originally intended by Fed monetary policy.   The key decision factor for the Fed is not whether this is the right time to raise interest rates at an economic level, but whether there are other more critical forces restricting growth and, as such, whether it is prudent to continue to juice asset/debt markets.  In a low growth environment a ZLB interest policy is only going to create further divergences between asset prices, asset focussed MS/debt and GDP and other key flows supporting GDP.  

I also believe that China’s current problems are signalling an end to the belief that weak growth post crisis was temporary and that unconventional and unusual monetary policy supporting asset prices/debt was valid and the risks containable.  Otherwise, well, interest policy is no more than a “hope and pray” one that supports the build up of market and financial risks relative to growth. 

Thus the Fed when deciding whether or not to raise rates is ultimately deciding the size and timing of the end game: a greater risk later or a lesser, but by no means small, risk now.  I suspect the Fed realises it has delayed a rate rise for far too long, but I also question whether it wishes to sustain the impression that it can be swayed by short term market movements forever.  Does it want to be looked upon as Sisyphus eternally dropping the interest rate ball?   

China rebalancing, a crisis? Yes, and one of magnitude and complexity.

China did not end up with its current imbalances as part of a natural process and therefore the transition itself is unlikely to be natural. 

China is both the here and now and the future, it has untold potential, a growing debt problem (here, here, here, here, here and more in the links below) and a “government” still “seemingly” capable of pissing great distances into the wind.  But working out China for many is tougher than working out the meaning of life itself.

I have concerns over the ease and the speed with which many believe China can rebalance itself from an export led/debt financed investment growth model to a debt financed services and consumption growth led model.  That is how China can transform itself from a manufacturer of goods to the world and builder of infrastructure, to a perfect model of advanced western capitalism? Odd really given that neither model appears to be stable or perfect in its entirety, both representing forms of economic extremism, excess and various levels of maturity/immaturity. 

The issue is not debt alone, but the rate at which it has recently accumulated, especially post 2008 and the imbalanced nature of the economy upon which it rests.  Just because an economy has potential, just because compared to more mature developed country metrics China has some way to go in absolute terms, does not mean that the current force exerted at the turning point is inconsequential.

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The Centre of Gravity of Risk and its Sensitivity has long since shifted towards the financial.

China is a key piece of the puzzle and much more so than people understand.  Without weighty Chinese domestic demand growth the transition out of untoward monetary policy towards financial and economic stability is jeopardised further.  Monetary policy had stabilised and propelled markets higher, but the time horizon for economic and financial normalisation is highly dependent on the timing of key transitions. 

The world economy is changing, decelerating, maturing and transitioning.  The world’s central banks, from the late 1990s onwards, co-opted the financial system to drive growth forward.  We have suffered a number of shocks as a result, but the strategy of juicing growth has continued. 

Our biggest immediate problem is not that the growth rate of expenditure is decelerating, or that populations are aging, but that the debt (and other contingent liabilities) that has been built up through a low interest rate and asset focussed monetary policy in the developed world and more recently, through infrastructure and other capital investment expenditure in the developing world, has created a mismatch between the supply and pricing of assets (debt and equity) and the economic growth rate on the other hand.

It is not that the fundamentals of underlying economic growth have become more volatile but that the relationship between monetary policy and assets and that growth has widened. 

I have written on this issue many times in my posts: it is not the economy we should fear but the financial system, its volatilities, risks and divergence.  Many still are ignorant of the shift in sensitivities from the economic to the financial: whereas in previous asset market history asset market movements had less impact on the here and now, their impact has become increasingly important.  The centre of gravity has shifted as the weight and importance of assets and debt to growth and the financial system has ballooned.

There are of course other problems that are making things worse: increasing income inequalities and falling productivity growth and of course the global structural imbalances that have arisen as China took centre stage in global manufacturing supply chains.

Slower growth and aging populations are likely inevitable and natural depreciation of the capital stock at the margin, in the absence of a shift upwards in productivity, via a shift of flows towards current consumption and away from investment is natural and self adjusting.  As flows shift away from capital investment we will also likely see lower growth rates in debt and money supply growth and the natural dynamics of decline means that this shift in flows may ultimately result in a decline in endogenous money supply growth, loans and other forms of debt and declining asset values. 

What is happening  is that the financial system is fighting demographic shifts, income inequality dynamics, transitional shifts between developed and developing economies, productivity stagnation in the hope that these dynamics are all transitory.  Apart from the transitional shifts between global economies there is much less certainty with respect to the other factors.  Importantly within discounted present value calculations, the largest component of value is held within the short to medium term horizon. So even if certain dynamics are transitory, the horizons are in conflict.

I see much potential volatility in the near term and much uncertainty with respect to fiscal and central bank accommodation of the divergence itself.   What the slowdown in China is bringing into the open is the divergence, the importance of the time horizon and the risk that normalisation of the growth trajectory is not going to happen, at least within a time frame meaningful to supporting the asset price/GDP dynamic divergence.  This is why markets are currently highly volatile and the major reason why the price adjustment is likely to continue.

See also:

A world in transition, but so many straws in the wind, some thoughts!

Not a “Savings Glut” per se but a monetary excess amidst a period of complex global structural economic change!

Was the US Q2 GDP revision so great?

The main changes to Q2 GDP came from revisions to non residential fixed investment, inventories and government spending.  But we must a) also remember that the prior GDP base had also been reset lower following the most recent GDP revisions and b) consumer credit growth has become increasingly important to GDP growth of late (as it has in places like UK):

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The Zone of Interest…I think Ellen has argued very forcefully for best interest standards!

The Zone of Interest is a book by Martin Amis that fictionalises the administrative zone of Auswchitz (and I highly recommend it).  An investment world without best interest standards, where the old, the infirm, the weak and vulnerable are maligned, abused and consumed, is too a Zone of Interest:

I was particularly drawn to a recent article by Ellen Bessner, a lawyer representing financial firms and “advisors”, entitled “Serving senior clients is becoming a more risky endeavour”.

The article is about the increasing prevalence of complaints made by elderly investors and highlights a generalised case of a senior who complains, with the help of a family member, about investment performance (i.e. losses) brought about by unsuitable investments for his or her age.

The article then goes on to flesh out 4 reasons as to why this is happening, none of which discusses the fact that “advisors” are rarely trained to professional standards; commissions drive advice and transactions drive commissions; suitability standards drive transactions and not portfolio and hence risk management structures; recommendations and rationale are not required to be in writing and little or no point of reference with respect to the risk/return/asset & asset allocation/liability profiles of the often mixed bag of investments are ever provided.  Moreover no disclosure of the true nature of the relationship is likewise provided, and this has not changed under the CRM.  The construct is designed to deceive, designed to place people in a place where they are least likely to be able to accept the risks of the transaction relationship they have been guiled into. 

And, according to Ellen, the reasons why there are more complaints:

Number 1

Perversely Ellen blames the fact that aging populations has led to a drive to educate investors about their rights in contractual relationships: this education and information she says has led seniors to take their advisors to court, to seek independent judgement on their advice via the financial services ombudsman (OBSI) or to take their complaints to the regulators.  Perhaps Ellen would like no education over contractual investment relationships or dare I say it human rights: ignorance does indeed breed a blissful transaction relationship.

Number 2

The second point is really point 1 again, but I will elucidate: it complains about the fact that there is no cost to taking a complaint to OBSI, that you can hire a lawyer for free (though she does not let this one hang) and that “lawyers” see dollar signs when they see an elderly client with a financial complaint…those damned lawyers!  Ellen tends to omit a great deal of the road that often leads people to the point where they have no other option but to seek help from OBSI, lawyers and regulators, as well as the road beyond, and she also omits to opine on those “advisors” who never pay their regulatory penalties or those firms named and shamed by OBSI who refuse to pay up.  The picture has not been fully painted, but one point is clear, investors have rights and this a problem.

Number 3

Point 3 is about investors buying the highest yielding investments available, the highest risk investments available, because they have not saved enough and they need the highest returns possible to meet their expenditure needs.  So we have here an admission that yes, investments were not suitable but that the “advisor” was not responsible.  Responsibility is an important issue and present “suitability standards” allow “advisors” to avoid this nicety, this responsibility to balance risk/return and financial needs through portfolio structure, advice and education.   Ask yourself this question?  Where is the record of the process whereby the “advisor” made recommendations over structure and content appropriate to financial needs and risk aversion, the client declined and wanted something much more risky?  Well, it ain’t there and that is the problem, or a good part of it.

Number 4

Point 4 is a different matter and I am not sure why it has been slid into this argument, but it has its uses and I will aside here: in a best interests standard regime, advice and recommendations would focus on the needs and disposition of the investor of interest and manipulations of the sort described would find it very hard to survive. 

I think Ellen has argued very forcefully for best interest standards!

No need to worry!

I recently came upon an article entitled “What You Can Do About The Upcoming Stock Market Crash”.  The title was tongue in cheek and perhaps unfortunately so given recent events.  Nevertheless, it made a number of important points about the difficulty of knowing when a market is at its peak and when a market is at its lows, and of knowing in which direction and by how much a market is going to move at any given point in time.  Much of this I agreed with, but not all:

When you think about it that risk and fear will always be there no matter how far the market goes up, down, or sideways. So what can you do?

Be prepared for a crash at any time. If you need to withdraw money in the next few years or you want to cushion the blows, then you need to diversify your portfolio with enough bonds, cash, or other assets that won’t fall along with the stock market.

Once you figure out what is right for your current situation you don’t have to worry about what happens because you are controlling the risks instead of letting them control you. That means you are safe to invest your money today and start earning your way to the freedom you want for yourself and your family.

Points 1 and 2 noted above are more or less correct, but the last point I have emboldened is where I diverge.  You are never ”controlling” risk, just diversifying it relative to return, and if possible, its covariance, itself a function of risk.  You cannot control risk, only minimise its impact through structure.  You are certainly not safe to invest your money today and there is no guarantee that you will earn your way to freedom. 

Return is an important consideration when accepting risk and many today who use simple mean variance models assume that expected returns are invariant and that risk is only volatility around this return.  In a general equilibrium, random, independent price movement model it does not pay on average to delay or defer investment (any benefit is purely attained by chance), but even here you are hostage to the probability distribution since the expected return in Monte Carlo land is only the average of many outcomes, some of which turn out to be quite disastrous from any level.

But expected returns do matter and while timing your investment to maximise your returns and minimise your losses is impractical and impossible for the market as a whole to do, making value judgements about market valuations and economic cycles to inform you of the boundaries of return and its significance is I believe worthwhile if you possess the expertise..  Where people run into trouble is where they either lack the knowledge and expertise to make the type of judgements needed to define the boundaries of expected return, and its impact on structure, as markets and economic cycles mature or react to market falls and meteoric rises as if one is the end of the world and the other its never ending bliss.

Deferring new risky investment at high market valuations is a value call and a discipline, but it is an act which relies on knowledge of the significance of valuation differentials.  It is one of my concerns that “we” have been taught that we should invest in markets at all times irrespective of the valuation, the cycle and the specific characteristics of either.  One of the reasons the world has been through innumerable crises since the late 1990s is because we have ignored significant accumulating structural economic and financial imbalances and the differential between asset valuations and economic fundamentals.  In a well balanced world we could probably ignore valuations and invest at will, ignoring volatility. 

But then again context is everything.  While one may not invest/sell at cyclical highs/lows there is little reason to sell all (high) and then attempt to reinvest all (lows) at perceived key turning points.  Portfolios should adjust to the relationship between valuation risks and the time frame of their liability profiles and it is here where we need to pay attention to valuation risks since these do have material impact.   As markets rise returns fall and the risks to the ability of assets to meet future needs increases, and vice versa.  When returns and risks pass barriers of significance that is where changes at the margin need to be made.  It is therefore not a question of timing but of tangible discipline and its benchmarks.

And, of course, I believe we are in the middle of a very long period of global economic and financial fragility, so safe is a word I would eschew for some time.

Making sense of US employment data and the interest rate decision.

We have relative strength in certain sectors supported by a steady increase in employment and growth in consumer credit. The backdrop is weak domestic productivity and income growth, an unsettling composition of employment growth and global economic weakness, in particular a possible global trade shock centred in China. The US is still growing slowly and while there are signs the labour market is tightening there remains considerable structural slack and remaining structural imbalances of concern.

A rise in interest rates may well be needed in the light of growth in consumer credit, but I have concerns over the fact that wage growth has yet to ignite, that capital investment expenditure remains weak and that the Federal Reserve’s own views of economic growth potential may well be above that which the economy itself is able to produce. Has the US economy returned to the normalcy envisioned by policy makers and with it its interest rate setting policy? I think not, but I also feel that the divergence between income growth and consumer credit growth is a considerable problem and one that may come back to bite the US if China weakens further.

Has demand moved to a level that would generate capital expenditure that many feel is necessary to push growth back to higher levels and would a rising interest rate scenario cut this particular and necessary part of the cycle short? This critical intersect may be a key consideration in any interest rate decision.

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US – Some interesting charts on income, GDP and new manufacturing orders from recent data

There are some interesting patterns and trends in US data: so I do ask myself, are we at the peak of the current cycle, are we as far as debt and low interest rates can take us?

US income growth has long been acknowledged to have weakened considerably yet recent data shows that the trend has indeed been weaker than first thought.  Note the following chart showing pre and post revisions to chained per capita personal disposable income:


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Compromised by its many biases the Brondesbury report completely misses the point about fees!

From one critical perspective this report appears to blame consumers of advice for the outcomes of a business model compromised by transaction remuneration.  Little is said of the inadequacies of suitability standards and their regulation or of the failings of investment processes focussed on the transaction.  Lacking such balance the report appears to advocate for the transaction model and thus is pared of its credibility!

If you had stopped reading the Brondesbury report into Mutual Fund Fees at the first summary conclusion on page 6, you might have walked away thinking the report was in favour of fees for the right reasons:

“Evidence on the impact of compensation is conclusive enough to justify the development of new compensation policies.”

If you had read on you should be left in some doubt as to how much of a marginal benefit a move to fees would have on investor outcomes.  The report appears to build an argument that suggests investor behavioural biases are the most important vitiating impact on outcomes and that advisors are merely responding to their transaction requests.    

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The Brondesbury Report & Cultural Bias in the Regulation of Canadian Retail Financial Services…

I am going to delve into the Brondesbury report shortly, but first we need to step back and look at the frame we are in, because neither the Brondesbury report nor the CSA have fully explained this.

The CSA have unfortunately addressed mutual fund fee issues separately from the wider problems in the Canadian financial services industry and, most notably, separate from that of best interest standards.  There may well be a reason for this!

Aside from the investment counselling/discretionary client portfolio management segment of the industry, whose standards and responsibilities appear, to all intents and purposes, to be ignored as valid reference points in current deliberation, the frame we are looking at is the one that holds the advisory segment. 

The advisory segment is still regulated on a transaction by transaction basis with responsibility for the transaction effectively lodged with the individual investor.  This is a simple parameter to parameter model that aligns risk preferences and investment objectives, adjusted for some nebulous assessment of investment experience (often arbitrarily assigned), to a product recommendation.  The product recommendation passes through the parameters.   In the Securities Act, for instance, the provision of a transaction recommendation within an advisory registration capacity is not technically considered to be advice.

The KYC is not a portfolio/optimisation process.  In fact, if you were to hand a KYC to an investment professional they would have to bypass it to a more sophisticated investment process to construct, plan and manage an asset allocation and security selection that matched a given investor’s risk preferences/asset liability profile. 

The current culture assumes that investors come with requests on a transaction by transaction basis, that the KYC process is effective and sufficient and because of its simplicity is therefore simply understood.  An investor in this frame should be able to own the transaction with the advisor only responsible for the product advice and not the management, or the construction or the planning.  If we refer to the careful delineation in the Securities Act, the investor is not actually being advised. 

In this frame “the culture” assumes that it is the investor’s own behavioural biases that drive mis-selling and that the advisor must accommodate these biases or risk losing business: I phrase this with reference to comments that I will, in a later post, draw from the Brondesbury report.

I have a number of issues with this framing of the KYC process and so, it would seem, did the OSC way back in the late 1990s and the early 2000s –note the FAIR DEALING MODEL and earlier Financial Planning Project initiatives: 

In 1999, the Canadian Securities Administrators committee on financial planning proficiency standards identified conflicts of interest in financial planning advice as a more significant concern than representatives’ proficiency. The CSA committee undertook to pursue this area as the second phase of the Financial Planning Project. Around the same time, OSC Chair David Brown determined that changes in the social and economic environment, and in the business structures and objectives of the securities industry, warranted a fundamental re-examination of the regulations governing the delivery of financial advice to retail investors. He recognized that our regulations are still product-based, as they have been for decades, even though the industry has moved to an advice based business model. In early 2000, the OSC launched the committee that has led to this Concept Paper.

The promise of service has long since exceeded that of the simple transaction. It has long since extended to the provision of advice that relates to overall financial needs and financial assets.  The process needed to manage these needs and assets is more sophisticated/complex than that provided by the KYC parameter model.

Today the KYC remains as the barometer of the suitability of product advice and the assessment of the suitability of advice.  In order to deliver the promises that the industry is effectively making the investor today you would need to move your focus of attention to a more complex and integrated service process.  In truth investors should be paying for the process and not the transaction.  Unfortunately the industry remains mired in a culture that rewards the transaction and not the process, and hence focus has remained on the transaction and transaction remuneration. 

If we are to deliver on the service promises being made we need to develop our processes and thereby raise our standards of advice.  By removing remuneration from the transaction and aligning it to the process, i.e. a fee for service process and advice, we change the industry from one focussed on transactions delivered by a rudimentary process to one focussed on advice delivered by modern technology and knowledge that better matches the promise.   At the moment advisors can effectively promise best interests yet remain regulated on the transaction.  This risks a disconnect between the processes needed to deliver the wider promise and those needed to satisfy minimum standards.

The Brondesbury report, along with many others, is stuck in the transaction mindset: 

It believes in a world where investors initiate and are able take control of their investment decisions, where the KYC is simple and effective in delivering investment solutions, where advisors are not promising a higher standard of advice and are hostage to investor behavioural biases and where advisors are not responsible for educating the investor over their process and disciplines.  It believes in a world where the cost to the investor of delivering the transaction solution is of equivalent value to the investor and where there is no other promise than the transaction and no other alternative spectrum of advice.  The report ignores the fact that today’s promises exceed the boundaries of KYC suitability and require more advanced processes that naturally differ from those required to deliver stand alone product recommendations.

The Brondesbury report is looking at the problem through the rear view mirror, replete with longstanding cultural biases that have impeded the development not only of higher professional standards but more efficient and cost effective wealth management solutions.  This is a very complex area. I will address some of the wider issues as I explore the Brondesbury report in subsequent posts. 


I discuss issues with the current parameter to parameter suitability model in my submission to the CSA on Best Interest Standards in Appendix A.  Also in this document are a number of excerpts from many of my blogs on best interests and the KYC process. 

Also worth reading is “Fiduciary Obligations of Broker-Dealers and Investment Advisers” by Arthur B Laby. 

Are Canadian regulators ring fencing consumer investing behavioural biases in favour of transaction returns?

“we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.” P53 of the Brondesbury Report on Mutual Fund Fees.

I am in the midst of reviewing the CSA commissioned Brondesbury Report on Mutual Fund Fees and am ploughing through the reference material which supposedly underpins its conclusions.  Amongst the many nuggets I have unearthed is the following taken from “Investors’ Optimism: A Hidden Source of High Markups in the Mutual Fund Industry” :

Previous works have identified investors’ optimism bias towards equities issued in their domestic market. In particular, academic research on mutual funds has focused on investor’s lack of financial literacy. …These empirical findings of investor’s deviation from rationality are in line with our model’s emphasis on investor’s limited financial knowledge of the mutual fund industry.

Investors’ optimism bias can be closely related to their lack of knowledge of the fund market, leading them to choose sub-optimal benchmarks such as bank savings instead of low-cost index funds or ETFs. Besides, investors’ optimism bias is probably influenced and reinforced by the marketing practices of mutual funds, which promote the sale of fund shares.

The reference to sub-optimal benchmarks is both noteworthy and ironic because both the new Point of Sale disclosure documentation for mutual funds and the performance reporting requirements laid down in the CRM2 lack mandated performance benchmarks. 

Interestingly the Canadian Securities Administrators had earlier proposed a GIC or cash based benchmark for Point of Sale mutual fund disclosure documentation, but baulked at the last minute for a number of reasons. 

So why were Canadian regulators looking to implement “sub optimal benchmarks”?  Were they ring fencing consumer behavioural biases in the interests of transaction remuneration or were they themselves acting in ignorance?  We may never know but the point is an interesting one and much more so given the deeper contextual focus in the  Brondesbury report on investor behavioural biases (chapter 5):

“Behavioral biases of investors are not easy to overcome. Behavioral biases affect advisor behaviour (just as advisors affect investor behaviour), investor choices of investment, and ultimately, investor outcomes”

“Time is a precious commodity to most advisors. There is only so much time an advisor can afford to spend to overcome the behavioral biases of investors, regardless of how they are compensated”

Investor behaviour biases lead to sub-optimal returns and these biases can be confused with compensation impacts

Behavioral biases of investors are not easy to overcome and they are a key factor in sub-optimal returns on investment. This poses a real limitation of the conclusions we can draw from the research literature, when we look solely at clients of commission-based advisors.

If there is no comparison between different forms of compensation, one can easily be misled into believing that sub-optimal behaviour is the result of the advisor’s recommendations and not, at least in part, the behavior and attitudes of the investor.

There are two issues related to behavioral biases that must be mentioned here. The first is the question of who is responsible for overcoming the behavioral biases of individual investors. While helping clients to do so may be something that a top-notch advisor will choose to do, we are not aware of any rule or principle that points to de-biasing as an advisor or a firm responsibility, regardless of compensation scheme unless a failure to do so impacts ‘investment suitability’ in some way.

“we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.” P53 of the Brondesbury Report on Mutual Fund Fees.

This quick post introduces some of my concerns with the Brondesbury report and my belief that many of its conclusions and analysis remain mired in a transaction mindset that continues to beset regulation of advice in Canada.   Regulators and, it would seem, some esteemed others appear mired in a perplexing behavioural bias towards “what does and does not represent investment advice”. 

How far can we defer the next asset price crisis? Depends on how fat the tail of the distribution is!

I have blogged on fundamental liquidity issues recently and one point that I want to bring out is that the greater the divergence between asset values and GDP and the greater the divergence between broad MS growth and GDP growth, especially in slower growth frames, the “fatter the tail of the distribution”.  

Volatility at one level is a measure of the sensitivity of an asset’s price to new information, shocks to the system/de facto changes in the energy of the system.   It reflects changes in demand flows for assets which can reflect changes in risk preferences and risk/return expectations.   In a general equilibrium volatility is meant to be a static physical characteristic reflecting the fundamental nature of the asset and its relationships, but we do not currently have general equilibrium relationships and volatility is not a stable measure of anything.

Essentially when we have excess asset focussed money supply growth (EAFMS) amidst a slowing growth frame the “accumulated liquidity in” decisions exceed the “present value of future liquidity out” (PVLO) decisions.  In a sense liquidity (at its heart a function of the relationship between asset allocation decisions and C/S/I/P decisions) becomes more sensitive to short term  changes in demand flows and risk/return expectations, risk preferences and other factors.   As the ratio of EAFMS to PVLO rises so does the natural volatility of the system.

Why the tail?   Why not volatility at 1 standard deviation?  During periods of excess monetary flows demand changes are not in totality covariance issues (ie. relative attractiveness of one asset to another) but absolute flows that suppress relative price reaction.   In other words we see a fall in volatility throughout most of the distribution.   All the while the system due to EAFMS/PVLO imbalances becomes more sensitive to changes in flows, preferences, expectations and shocks.  

Given that the system because of its imbalances becomes more sensitive to small changes in any one factor, the bigger the divergence noted in paragraph A the greater the probability of an extreme risk event.   The greater the accumulated liquidity in to PVLO the larger the tail: the risk event and its probability increase. 

In reality, from a given point on, we can effectively discount the rest of the distribution in any analysis as a dynamically widening tail is merely a statistical constraint on the way we should be viewing risk.  We are only exposed to the wider risk distribution if forces suppressing risk remain influential.  

A Foray into the Fundamentals of Austerity in Anticipation of the Outcome.

A recent IMF report pointed out some supposed vast amounts of room available for the world’s economies to step up government borrowing to finance consumption, investment and production decisions.   Oddly the report appeared to ignore other forms of debt and material deterioration in key areas of the economic frame.  

When the crisis broke back in 2007 it was clear to me that monetary and fiscal policy would likely need to go for broke to support economic growth and employment at a time of collapsing asset values, debt defaults and a world wide retrenchment in expenditure of all kinds.   As it happened a great deal of that support went into asset prices and financial institutions.

But some years after the crisis, after a slow and drawn out recovery with interest rates locked to the floor, economies still appear to be borderline reliant on debt financed government expenditure.  Any attempt to reduce borrowing, to either raise taxes or cut expenditure to pay back debt would be considered by many to have an adversely negative impact on economic growth, especially at such low growth rates. 

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On the question of market liquidity and the liquidity time bomb.

In a recent tweet I made the comment “Not a paradox: ratio of MS to assets & of asset prices to GDP, and hence to GDP functions C/I/S/P out of synch”.

Given the sensitivity of markets to even small changes in demand should anyone stand ready to provide liquidity at the onset of the tail of a distribution?

If a liquidity decision eventually exits, then there is a maximum amount of divergence which any given financial system can accommodate before the dynamics of the reverse flow overwhelm any attempt to keep it afloat. We must bear this in mind.

A recent article by Nouriel Roubini “The Liquidity Time Bomb”, to which the tweet responded, commented on the apparent paradox between vast amounts of financial stimulus and monetary expansion alongside a decline in market liquidity for assets.  

Why do we need liquidity in the market place?  There are a variety of fundamental economic reasons.  Entities wishing to purchase assets (from savings out of income or from loans) in either new/existing issues, entities who may be dissaving and wish to sell assets in exchange for cash for either consumption (debt repayment) or to purchase higher yielding assets, businesses that wish to raise capital and other entities like governments that wish to borrow.  That is markets function as an important medium for saving, consumption, investment and production decisions…they facilitate the allocation, pricing, accumulation (and the reverse) and transfer of capital ownership rights.

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In the context of interest rate decisions you have to ask yourself just what are we waiting for?

I have seen that the IMF has asked the Fed to defer interest rate increases until we see clear signs of wage increases and inflationary pressure.

The request IMO is both scary and rationale given that so much of today’s National Income Accounting Identity (output=C+I+X-M) relies on factors that lie outside of its operation.  I speak of new bank generated loan growth given that income growth/distribution and investment growth still appear to be weak in the scheme of things..i.e. C+I the drivers. 

The last time the FRB delayed interest rate increases we had a debt financed consumption boom in the US followed by IR increases and a de facto financial collapse.   By raising rates we likely restrict one of the few modes of generating consumption growth in the US (note auto loans) and many other countries.  We also likely raise the impact of existing debt burdens on what are to date still historically low rates of income/wage growth.  

As such you have to ask yourself just what are we waiting for?  Well we need higher income growth, but not just higher income growth: we need a more equitable and fair distribution so that economic growth itself becomes less reliant on debt and low interest rates, and less exposed to the scary divergence of asset values. 

But the world is also changing in ways that question whether we can effectively outwait the inevitable: populations are aging and declining.  Areas where the frame can still expand in consumption terms, areas such as China, may be heading into their own period of slow growth and low IR debt support. 

Importantly will the status quo submit to a reconfiguration of the pie and can the world assume a less debt dependent economic raison d’etre?  

So yes, the rationale to defer interest rate rises is both scary and realistic, but it fails to answer important questions: what are we waiting for, how long can we wait, and are our hopes realistic? 

This is just a quick 3 minute post, but the issues are critical!

US Manufacturing Orders

After a strong mid 2014 new orders had fallen heavily with nominal order data especially hard hit.  After an initial slide the trend seems to be levelling out, but levelling out is not what the economy needs.

Long term, the order profile is flat if we adjust for prices – note I have adjusted for producer prices not order prices, although over time I expect little difference.


Annual growth rates have taken a punch to the gut, but if we adjust for monthly variance and producer prices we find that the downturn is less marked, although not necessarily insignificant:


What I do find interesting, and which backs up my thoughts re last summer’s surge in activity, is the fact that the rise in activity towards the middle of last year is more or less reflected in the downturn in the early part of this year.   This pattern comes about after adjusting for PPI and basing % changes on rolling 6 month average data to arrive at a better fix of actual capacity and order flow:


Motor vehicles and parts seems to be the notable exception, but I do have concerns over debt financing and weak income growth.


World Trade

Some charts and brief comments I forgot to post:

Growth in world trade volumes has fallen off significantly since summer 2014:




Interestingly US trade data shows a tail off in US auto exports and a rise in Auto imports.  Imports rose strongly in March and fell back in April (opposite for exports), although much of this has been ascribed to the impact of West Coast port strike issues.

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Comments on “Developments in credit risk management across sectors”

A recent BIS report on “Developments in credit risk management across sectors:” raised some interesting points regarding the stability of the financial system.  What I found interesting was the increasing use of collateral agreements and in particular higher quality/more liquid assets.   If the financial system is exposed to a risk event there is a risk that this collateralisation of higher quality assets could increase the correlation of these assets to the risk event and may well end up drawing liquidity from other areas.  Likewise as risk in the system increases the need to hedge and hence post collateral may further infect expected price reactions.

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Is Private Investment Expenditure in the US really looking strong?

Is investment expenditure in the US really looking strong?   I picked up some tweets on this the other day which stated that it was indeed.


The above graph shows domestic investment of US private business net of capital depreciation. A couple of points should strike you immediately: one nominal expenditure peaked back in the late 1990s; two, a lot of the retracement (or the pluck as Friedman might have said) is a consequence of the unprecedented decline seen during the dark days of 2009.  

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