Helicopter Money…Japan..25 charts

Japan has been at the forefront of weakening GDP/wages/growth, deteriorating demographics, elevated sovereign debt and extreme monetary policy.   Of all the major economies, given its existing debt burden and aging population, Japan is arguably the closest to Helicopter money.

Post 2012, policy (Abenomics) aimed at stimulating demand, generating wage growth and inflation has failed with respect to the specific objectives set.  But then again, what is an optimal level of consumption in a declining demographic paradigm?  Perhaps in the modern world it is one which drives growth to the point that current debt levels become manageable, or where risky assets provide returns commensurate with the consumption liabilities expected to be provided by them.   In this context, global Central Banks have been consciously attempting to manufacture growth for at least a decade.  Helicopter Money would however break this intercession, acknowledging that only more money supply and more debt relative to growth can support the expenditure/infrastructure side of the balance sheet: it is difficult to comprehend just how the asset side of the balance sheet would evolve in such circumstances.  I suspect that there would need to be an adjustment, a reset, but even that would be only half the story.  That said, on to Japan:

Japanese real GDP growth has been sliding heavily since the bursting of its own asset  bubble starting in 1990:

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Helicopter drops: feeding the animals in order to keep the zoo in business..

I was reading “Helicopter drops might not be far away” by Martin Wolf in the FT.  By now those interested in macro economics/monetary policy/asset markets should be well aware of the long gradual easing in interest rates, especially since the 1990s.  Lower interest rates did not just encourage people to borrow for consumption, but they also boosted the amount of borrowing for asset purchases with rising asset values also looping back into consumption for a while.   During this period, global money supply growth also became ever more asset focussed. 

For a while this helped stimulate consumption in key economies, also aiding in developing economy growth.   Developed economy consumers became ever more indebted at a time when income growth was also slowing, but given that asset markets kept rising and interest costs kept falling, everything was able “to keep on going for a while”…many felt that this period of low interest rates and rising asset markets was a “great moderation” and few seemed to notice the enveloping divergence. 

While the financial crisis was the bursting of this particular reality, it also marked the onset of a period of unprecedented financial engineering in response, itself a denial of that reality. 

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Correlations, volatilities and expected returns as the monetary tide reverses flow..

I note comments by El-Erian over Central Bank’s inability to suppress volatility as a bigger risk than China and I would agree although I would qualify this in terms of the immediate asset price risk.   Asset focussed money supply growth and asset price relatives (relative to GDP growth and income growth as well as its distribution) are all deeply negative for asset markets when liquidity dynamics, amongst others, change.

Recent commentary by Zero Hedge on the winding up of Nevsky Capital is also worth reading: the Nevsky Capital report suggested that a disciplined structure can no longer be counted on to realistically manage risk and return given the uncertainty of an increasingly skewed distribution of possible outcomes in an environment worryingly distanced from fundamentals/exposed to unconventional monetary policy; liquidity dynamics in the market place also impacted.  

Another interesting piece of data shows the 10 year rolling returns on commodities that I found in a tweet from @zatapatique.

I have written on the issues of excess asset focused money supply and liquidity for some time (relevant posts of mine).

Many portfolio management structures depend on expected return/correlation/standard deviation assumptions that would be very much exposed to a break in the direction of money flows towards assets.  All statistical measures of risk and co variance are drawn from the impact of monetary demand flows for assets.  In an environment where monetary policy is accentuating flows to asset classes as well as expanding the quantity of money and reducing the supply of certain asset classes the natural flow response to risk and return in the environment are muted.  As unconventional monetary policy recedes, additions to the quantity of asset focussed money and interest rate support reverses, the natural flows not only start to reassert but the prior excess flows adjust to the new environment.  We get a break out of trading ranges and covariances.

This is all incredibly risk and uncertain for those dependent on traditional statistical measures of asset price sensitivities and covariances.

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?   

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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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!

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

If you stream through the data it is pretty clear that developed economy growth has been slowing for some time and that monetary policy has accommodated this adjustment with lower interest rates and a relaxed attitude towards money supply growth.  At about the same time these trends were moving ever closer to their sweet spot on the horizon (because we are not yet at peak of this particular movement) certain developing markets really got going, with the help of a fair amount of their own monetary stimulus but also by a reconfiguration of global supply chains and offshoring in key economies.  All factors combined to create a heady and dangerous global financial imbalance, a weak bridge cast across a widening economic divide.  No wonder it all came crashing down..but who was to blame?  The world’s central bankers who were blindsided into excessively lax monetary policy by a low inflationary world that had become obsessed with laying off and chopping and dicing of risk to those “who could best absorb and bear it”, or some of the finer strings in the mesh?  Well, some have chosen to blame excess savings in the emerging/developing part of the world, principally China, but this is all too pat.   The “savings glut” theory, if you can really call it “excess savings”, was merely a return of serve of part of the vast ocean of financial and monetary excess that barrelled through the early to mid 2000s.

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The Fed is slowly shaking the tree, but will it start to climb?

Over the last 20 or more years interest rates have fallen, for reasons other than falling inflation, and as interest rates have fallen so has nominal growth in a great many developed economies, and so has inflation fallen further.  On the other hand debt has risen and so have asset prices, quite remarkably so in fact.  But through this period we have also had a succession of financial and economic crisis, with the risk mostly of a financial nature, and in response to these asset price risks, interest rates were either cut or held low for, in my opinion, far too long.

The Fed would now like to raise interest rates, and so too would other seemingly “well on the way to economic recovery nations”.  The trouble is the “economy and our markets” are now more than ever sensitive to changes in interest rates.   The Fed partly knows this, is partly concerned that interest rates lie at close to zero (and unless they want to go negative, a place they probably worry they may never climb out of) would like to see them a bit higher, to allow them to cut interest rates in a subsequent crisis. 

In the last cycle the the Fed Funds rate rose to 5.25 and currently loiters around the 0.11 to 0.12 range.  I would suspect that a Federal Funds rate of 4% was too high for the last upward cycle and would also posit that rates would be hard pressed to rise above 2% in the current cycle before we saw the type of wrenching market reaction…but this all assumes everything else being equal.  Markets are too well worn around the interest rate, money supply asset price equation to lay back and wait for the interest rate cycle to hit economic growth.   The question is though how much of an asset price shock can the “economy take as interest rates rise before that asset price shocks impacts the economy?  I guess that is the question and the Fed is trying to work out just how sensitive the world is to a rise in interest rates.  It just does not know and while the risk of rising rates may be extremely high it may well have figured that “the Fed’s got to do, what the Fed has got to do…”.  

As many other commentators have pointed out, a whole panoply of other risks have started to move out of the closet (namely the many risks posed by a sharply appreciating US dollar), risks that may already constrain the Fed from acting.

Current rates on 5 year treasuries are around 1.5% and stood at some 4% in early 2007.  I would have thought that the peak rate for the Fed rate would be around this level at the current juncture, but just how to get through to it is the question? 

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Central Banks and bubbles..

I do find it funny to see how many rely on the words of central banks to determine whether markets are or are not in bubble territory.   Central banks these days are in the business of mind manipulation for the furtherance of asset price stability and economic survival and to expect them to malign the object of their obvious intent would be insanity.  Central banks are supporting asset prices for balance sheet purposes and to suggest these prices were in bubble territory would be counterintuitive.  

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Fama on tapering–it all depends on your view of the Fed and the market.

Just watched a short clip on Zero Hedge with Ric Santelli and Eugene Fama discussing tapering.  Fama said that tapering would be a neutral event.

Fama’s point was that tapering is a simple balance sheet exercise whereby the Fed transfers the securities it has bought for the short term debt (deposits) it has issued.  I guess in a sense, if it is a neutral exercise, the impact would be determined by the interest rate differential on the two.  But it could be a lot more than this.

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An exercise in going where your thoughts lead! “Perhaps, perhaps” says the Fed about QE!

On its own, I would not place too much weight on today’s movements in US securities: people have been building up the pricing risk of a change in Fed Strategy for some time and today’s movements reflect only a very miniscule readjustment. 

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As it came to pieces in my hands…

Paul Weller: “I stood as tall as a mountain; I never really thought about the drop; I trod over rocks to get there; Just so I could stand on top; Clumsy and blind I stumbled;…I didn’t stop to think about the consequences; As it came to pieces in my hands.”

The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances.

We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return. Have we built up a bigger monster, and if so, how do we slay the beast?

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Is this the last kick of the can for monetarism as we know it?

I am not so sure that such a narrow focus on the monetary base as the de facto cause of current economic problems is a safe way to be conducting monetary policy.   Agreed, in a general equilibrium, and in most normal economic scenarios, increasing the monetary base is going to stimulate economic activity – give banks more deposits to lend at an acceptable margin and they are likely to do so – but I am concerned that today’s monetarists have lost the plot.

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Aggressive, desperate or, by necessity, both? Is this the last throw of the dice?

I hate the phrase quantitative easing, it is a bit like calling an apple, Malus Domestica-Borkh.  But QE is no apple, it is a rigged game as far as investors are concerned, and the Fed is playing on the market’s irrationality, and its passion for the short term, to pump a little more blood into the valves. 

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