June 9th, 2014
by Lance Roberts, Streetalk Live
This week's article is a heterogeneous amalgamation of reflections on recent events, the most important of which was the European Central Bank's (ECB) push into a negative interest rate policy.
The European Central Bank took extraordinary steps this past week to stave off the threat of deflationary pressures in Europe. This included cutting key interest rates below zero for the first time in a bid to get banks to lend more to credit-starved customers and would make, for a start, up to €400 billion ($545 billion) in cheap loans available to banks later this year. The ECB hopes that the banks will lend more to the private sector in the future.
The lengthy four-year maturity on the loans is another first for the ECB and it underscores the worry that sluggish consumer prices and falling credit could create a self-feeding spiral, depressing wages and job creation as well. For now, the ECB stopped short of more direct liquidity interventions it has considered, such as the kind of asset purchases deployed in recent years in the U.S. and U.K.
The problem for the Eurozone is shown in the following chart:
Abnormally high levels of unemployment leave little demand for credit. However, Central Banks continue to operate under the premise that by providing cheaper credit, consumers will borrow in order to consume. However, this Keynesian economic theory is based on a flawed assumption that consumption comes before production. Patrick Barron at the Ludwig Von Mises Institute made a great point recently stating:
"Keynes's dogma, as stated in his magnum opus, The General Theory of Employment, Interest and Money, attempts to refute Say's Law, also known as the Law of Markets. J.B. Say explained that money is a conduit or agent for facilitating the exchange of goods and services of real value. Thus, the farmer does not necessarily buy his car with dollars but with corn, wheat, soybeans, hogs, and beef. Likewise, the baker buys shoes with his bread. Notice that the farmer and the baker could purchase a car and shoes respectively only after producing something that others valued. The value placed on the farmer's agricultural products and the baker's bread is determined by the market. If the farmer's crops failed or the baker's bread failed to rise, they would not be able to consume because they had nothing that others valued with which to obtain money first.
But Keynes tried to prove that production followed demand and not the other way around. He famously stated that governments should pay people to dig holes and then fill them back up in order to put money into the hands of the unemployed, who then would spend it and stimulate production. But notice that the hole diggers did not produce a good or service that was demanded by the market. Keynesian aggregate demand theory is nothing more than a justification for counterfeiting. It is a theory of capital consumption and ignores the irrefutable fact that production is required prior to consumption."
There is one other issue with the idea of government stimulus. Paying people to produce something is one thing; however, the dollars used to pay those individuals came from the taxes on income that was derived by production elsewhere. Production MUST come first. Despite the Federal Reserve's ongoing balance sheet expansion, there has been relatively little economic expansion outside of what has been driven primarily by population growth alone.
Caught In A Liquidity Trap
In July of last year, I wrote a rather extensive piece discussing "What Is A 'Liquidity Trap' And Why Is Bernanke Caught In It?"
"A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels."
The reality, however, is that it is not just the Federal Reserve that is trapped at this point, but Japan and the Eurozone as well. The charts below show the trend of economic growth as compared to key interest rates for all three areas.
While Japan has been at this game the longest, it is interesting that the US and Eurozone both believe that despite the abundance of evidence to the contrary the outcome will be different.
With this in mind I found these comments from Bloomberg on Friday rather interesting:
"'It will not help the prospect of a functioning money market because banks will not be compensated for the risk they are taking,' said Orlando Green, a fixed-income strategist at Credit Agricole Corporate & Investment Bank in London. It would make more sense to lower the benchmark rate, thus reducing the interest banks pay on ECB loans, and keep the deposit rate where it is, Green said.
Other institutions have opted against such a move. The Fed started paying interest on deposits to help keep the federal funds rate near its target in October 2008 and have reimbursed banks with 0.25 percent on required and excess reserve balances since December that year. (That is about $2 Billion a year in interest to Fed Reserve banking members.)
Some Fed policy makers, last August, argued that reducing the rate could be helpful in easing financial conditions. While they discussed doing so in September, many expressed concern that such a move "risked costly disruptions to money markets and to the intermediation of credit," the Fed said in minutes published on Oct. 12.
The Bank of Japan (8301) introduced a Complementary Deposit Facility in October 2008 to provide financial institutions with liquidity and stabilize markets, and has kept the interest it pays for the funds at 0.1 percent since then. Governor Masaaki Shirakawa told reporters on May 23 there would be 'large demerits' to reducing the deposit rate because it could lead to a decline in money-market trading.
'If the ECB cut the deposit rate, it would take an important profit opportunity away from banks,' said Tobias Blattner, an economist at Daiwa Capital Markets Europe in London. By doing so, the ECB would also be 'encouraging banks to lend to the real economy' even though 'there's hardly any demand for credit,' he said. Blattner predicts the ECB will cut its benchmark and leave the deposit rate at 0.25 percent."
(We are already seeing signs of banks dropping lending criteria to force loans into the market. JP Morgan recently announced $100 billion Collateralized Loan Obligations (CLO), subprime auto loans are surging, and requirements for home mortgages are being reduced. All things we saw prior to the last financial crisis.)
"ECB Executive Board member Benoit Coeure said on Feb. 19 that market interest rates of zero or lower 'can result in a credit contraction.'
That's because banks, trying to preserve their deposit bases by paying customers a reasonable interest rate, may reduce lending to companies and households because the return is too low and invest in higher-yielding assets instead.
'A deposit rate at zero will be of particular support to banks in southern Europe because it could help encourage some flow of credit,' said Callow. 'A negative deposit rate can be damaging for money markets.' Negative rates would destroy the business model for money- market funds, which would face the prospect of paying to invest, said Societe Generale economist Klaus Baader.
'But the ECB doesn't set policy to keep alive certain parts of the financial sector,' he said. 'Policy makers want to show that they haven't exhausted their options yet.'"
There is no argument that the ECB, the Fed and the BOJ are "all in" using a very blunt monetary tool to try and stimulate organic economic growth. However, as stated above, without addressing the production side of the equation it is unlikely that they will be successful in the long term.
In the short term, the influx of monetary stimulus is likely to continue to support asset prices which continue to act as a "wealth transfer" from the middle class to the rich. These actions also continue to suppress will interest rates which fosters the chase for yield.
Pictures Of An Exuberant Market
There are many signs that exuberance in the market is reaching levels of real concern. It is not even being acknowledged by members of the Federal Reserve:
Fed's Kocherlakota Urges 5 More Years Of Low Interest Rates via Reuters
"Kocherlakota acknowledged that keeping rates low for so long can lead to conditions that signal financial instability, including high asset prices, volatile returns on assets, and frantic levels of merger activity as businesses and individuals strive to take advantage of low interest rates.
But that is a risk, he suggested, the Fed should be willing to take."
Fed's Williams Says Central Banks Need To Realize Investor's Aren't Rational via The Wall Street Journal
"In a world of rational expectations, asset prices adjust, and that is it, but if one allows for limited information, the resulting bull market may cause investors to get 'carried away' over time and confuse what is a one-time, perhaps transitory, shift in fundamentals for a new paradigm of rising asset prices."
The following charts support William's view:
The more I read, the clearer it becomes that the world's Central Banks have become caught in a "liquidity trap" which is entirely based on circular logic. Central banks must create asset bubbles in the hopes of stimulating economic activity. When the bubble eventually pops the economic activity evaporates which requires the creation of another asset bubble.
Isn't that the very definition of "insanity?" Repeating actions which have had historically negative consequences but hoping for a different outcome?
The Buy Signal Is In
In January of this year, the markets gave both a "warning" and then a "sell" signal in our portfolio allocation model. This would have normally been a signal to reduce equity exposure to portfolio allocation models. However, we opted not to do so as the markets had "technically" not done anything wrong.
The only reason that we went against our portfolio model signals was due to the Federal Reserve's ongoing monetary intervention programs. The excess liquidity has continued to act as a support for asset prices in recent months so we opted to remain allocated with a cautious eye towards to financial markets. This has worked out to our advantage so far.
The rise in the markets this past week have re-established the ongoing bull market trend and finally reversed the long-standing market "sell" signal as shown in the chart below.
The reinstatement of both portfolio allocation "buy" signals requires that portfolios be returned to full equity allocation at the present time.
However, I would recommend a bit of caution before increasing portfolio allocation models at this time because:
- The markets are EXTREMELY overbought
- Complacency and Bullishness are at historically high levels.
- This is the wrong time of year for "buy" signals.
- The Federal Reserve is reducing their support for the markets.
- Market internals continue to deteriorate.
I published the following chart last week as the market broke out of the consolidation pattern that had existed over the last several months. The vertical elevation of the market over the last several trading sessions has taken the markets to extreme overbought conditions on a near vacuum of volume.
For most investors, it would be much more advisable to await a pullback in the markets to the 1900-1920 range to increase portfolio equity allocations at this time. A break below 1900 will likely be indicative of a more intense sell-off.