From Terminal Velocity (3) – “The Pyramid Scheme”[i]:
Reading between the lines, it is clear that the Fed intends to maintain a large balance sheet of assets for some time; even after interest rates have begun to normalize. The Fed will then use a rolling form of Operation Twist, across the Yield Curve and across asset classes, in order to target particular areas that it believes need influencing. The overall size of the balance sheet and its composition will then be managed, to achieve a background of benchmark interest rates for specific capital market sectors and the economy in general. This balance sheet management will involve increases and decreases in overall size, in addition to substitution of different assets and maturities. In this way, the Fed intends to anticipate and prevent bubbles or excessive tightness in liquidity from occurring.
It therefore looks as though the Fed will allow QE to roll off via expiry; and that it is quite prepared to provide specific monetary support to specific credit instruments, even as interest rates are rising in general. The intention and capability are to make the economic recovery sustainable during the rising rate environment.
Chairman Bernanke’s recent speech, at the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, entitled Monitoring the Financial System[ii], gave further insight into how the Fed is going to use its expanded balance sheet. In Bernanke’s latest signal, the expanded balance sheet will be used as an anchor for macroprudential stability; in addition to being the monetary base for economic growth. Since the crisis of 2008, the Fed has evolved to become a more holistic regulator and operator. Bernanke was however clear about the limitations of such a holistic view. He clearly defined two related features of systemic risk, “Triggers” and “Vulnerabilities”. The Fed’s ability to foresee “Triggers” is limited; and its track record is as poor as any other market observer. This operational weakness can however be mitigated by the Fed applying oversight and regulation, to reduce the systemic “Vulnerabilities” in the financial markets.
Principle sources of “Vulnerability” were listed by Bernanke as:
- Systemically Important Financial Institutions (SIFIs)
- The Shadow Banking System
- Collateral Financing Markets
- Non-financial Institutions
Clearly, Bernanke was making his pitch to get more regulatory control of financial markets. In practice this control will be enhanced by the Fed building up its balance sheet with financial assets, in the markets it intends to oversee and regulate more closely. The current expanded balance sheet directly lends itself to this strategy. As assets expire, they can be replaced with other asset classes that the Fed sees as being systemically important. This thesis implies a gradual drift in the composition of the Fed’s balance sheet, away from Treasuries towards assets that are more volatile and have higher credit risk attached to them. We would suggest that the current status of the global economy, which requires both monetary stimulus and simultaneous systemic strengthening, is leading the Fed (and all central banks) down this route.
Consider the alternative. Monetary stimulus and the disconnected raising of the systemic risk metrics simply move liquidity into risk free assets. In practice, the commercial banks take the central banks’ liquidity; and raise lending standards at the same time. There is then no lending and no growth; so the central banks have to do more monetary stimulus. This then leads to bubbles that threaten the whole system. Clearly the current financial architecture is inherently unstable. We believe that the Fed has adopted the holistic approach, via the expanded balance sheet, out of its practical experience during the recovery; rather than out of intellectual rigour. The current set of Developed Market Central Bankers such as King, Bernanke, Draghi and Fischer all come from MIT. MIT’s motto is “Mens et Manus”; which means Mind and Hand. This doctrine means that its disciples will apply practical experience to create practical solutions. We would argue that the Fed’s balance sheet has got to where it is because of practical necessity; and that it is now being used as a tool to manage the risk that has come from this action. Bernanke opined that there is “the apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable. Indeed, it may be that prolonged economic stability is a double-edged sword”. Clearly he was identifying the conditions being created by Fed policy at the “Zero Bound”. Bernanke has grasped “the double-edged sword” very firmly; and intends to wield it with great care and perspicacity.
Bernanke’s favourite journalist, to leak coded messages through, was also active on the day that his source was officially speaking in Chicago. John Hilsenrath has made a career out of breaking the latest developments in Fed policy[iii], so it was with great interest that his latest piece in the Wall Street Journal was read[iv].
The article was clear; and picked up on Bernanke’s warning that markets are most “Vulnerable” to be “Triggered” when aggressive traders have reached for risk in a period of certainty. Bernanke wishes to make it clear, over the coming months that an element of uncertainty over timing of the exit from QE is going to be introduced. The markets should however not read this as a signal that the Fed intends to exit any time soon. Traders are being warned that the Fed does not want them to reach for more risk, or to dial back risk, over the coming summer months. This situation comes back to the observations of Michael Woodford at Jackson Hole last summer; where he stated that the benefits of QE have been undermined by those discounting its premature end[v].
Hilsenrath is quite explicit. Leading up to Jackson Hole, there is going to be a debate over who follows Bernanke in the Chair; and what this means for Fed policy. Clearly, not only markets but also the real US economy will observe this debate; and put all plans for expansion on hold. It is fair to say that even the global economy will watch and wait. There is therefore a risk that the global economy stalls. There is also the risk that the global economy continues to recover, so that the debate over Bernanke’s exit gets framed as a debate over when QE is ended. Bernanke wishes to anticipate these debates in advance; and warn markets to desist from violently discounting either option. Bernanke is trying to manage volatility, through communication. Between now and Jackson Hole clarity, in the tradition of Bernanke, will be drip fed (from the Fed) into the markets; so that the volatility is minimised.
Hilsenrath also signalled that Bernanke was trying to end what was termed the “distraction, diversion and dilution” of market attention over the next Fed Chairman in Terminal Velocity (7)[vi]. Allegedly, the list of candidates is quite long and contains[vii];
- Janet Yellen,
- Tim Geithner,
- “Number 3”
- Larry Summers,
- Roger Ferguson,
- Donald Kohn,
- Stanley Fischer,
- Christine Romer, and
- Alan Blinder.
Yellen, Geithner and Fischer were on our list already[viii]. “Number 3” is the most interesting name on the list, because it is Bernanke himself. Even if he isn’t the “Pilot”, his admission to the list signals that the “Helicopter” is coming. We think that these five are the real candidates; and the others are just making up the numbers; to make it look like an extensive search process. Geithner and Summers are presumably there to save the Banks; and Yellen and Bernanke are there to save the Middle Class. There are two categories; because thus far Obama hasn’t decided which constituency is in the worst shape and needs saving yet. There are two names in each category, to build in the redundancy in case of a hostile Congressional confirmation process. Fischer is the special team play; in case Obama needs to go outside the box and save both constituencies at the same time. As we opined in Terminal Velocity (7), when an extreme solution is needed the job generally goes to a foreign central banker these days. Fischer is a foreigner; who is not too foreign, by nature of his service at Citigroup with Robert Rubin. As readers may know, Rubin’s son James is a key adviser to Obama. Bloomberg has come out for Yellen[ix], so it is not surprising that over one third of the users it polled in a recent survey think that she will be the next Chairman[x]. This same survey also showed Bernanke at number two on their list.
As the crumb trail leads towards Jackson Hole, individuals are selected to add more crumbs which will prepare public opinion to accept “Bernanke’s Helicopter”. The New York Fed[xi], Sarah Bloom Raskin[xii], Amir Sufi[xiii] and Elizabeth Duke[xiv] have all been observed dropping crumbs. These crumbs all tend to come from the cake that is known as the “Wealth Effect”. As we opined in Terminal Velocity (8) this cake has been baked by Quantitative Easing, in the Fed’s oven; but it has not risen evenly across the economy. In particular, the indebted and low income demographics in society have not enjoyed this inflating cake. Holders of capital market assets have enjoyed the rise however.
Recent evidence from David Rosenberg at Gluskin Sheff suggests that individual American equity investors have had smaller slices of cake since QE started.
PIMCO provided some excellent analysis of the impact of the “Wealth Effect” through housing.
It sees strong evidence of consumer deleveraging. The deleveraging has been particularly pronounced in the “60-89” wealth demographic since the housing crash. This deleverage has been a mixture of voluntary deleverage and forced deleverage (loan foreclosures).
As a consequence, the current recovery in the housing market should be viewed as a recovery to less negative equity rather than a recovery to positive equity. The implication of this fact is both as nuanced as profound. The big peak in home equity, that was the symptom of the bubble and financier of economic hyperactivity, is therefore many years away. Indeed the bubble may never return, because consumers have long bad memories of it. It will take the creation of a bubble of similar magnitude, to return the economy to this previous former health however. We suggest that the Fed is engaged in this policy, using and extended balance sheet and the soon to be announced “Helicopter”. The Fed will be taking the unprecedented step of assuming all the bubble risk in prices onto its balance sheet, whilst providing the liquidity for a real economy to justify this balance sheet value with the “Helicopter”. The For fixed income risk assets, this bubble risk can be managed by just letting the bonds mature. Since the Fed at this time holds no equity risk assets, care must be taken by private investors and speculators in valuations and trading of them. This is why Bernanke has been careful to warn the equity markets not to get ahead of themselves and the real economy.
The impact of the Fed on the “Wealth Effect”, via the equity market, is therefore weakened; just as it has been weakened via the housing market. Americans are shedding paper and hard assets, in order to survive, so the Fed cannot stimulate consumption through asset prices. The Fed must therefore focus directly on consumers. One can therefore see that, by the time the crumbs have ended their trail at Jackson Hole, the appetite for the “Helicopter” will be healthy.
The San Francisco Fed added to the crumb trail, with its latest publication “Will Labour Force Participation Bounce Back?”, by Leila Bengali and Rob Valletta[xv]. Their conclusion is that Americans do not return to the Labourforce until employment has hit its last peak. The implication is that there are large numbers of discouraged workers; who will remain so until they see the next economic boom. Not only does the Fed therefore need to accelerate its attempts to get these workers back; it also needs to make sure that it does not kill the recovery, by exiting when the economy is back at the last peak and these discouraged workers finally show up. This study has profound implications for the exit from QE. The implication is that the Fed must tolerate an economic overshoot to the upside; which also supports the thesis of a balance sheet that is extended indefinitely. The Fed must create an economic boom and then sustain it, beyond the point at which the “Inflation Hawks” (and “Bond Vigilantes”) start calling for tightening. Bernanke will remember that the last time he tightened when the housing boom was going crazy, he “Triggered” a crash that was made “Vulnerable” by the fraudulent mortgage underwriting practices of the day. This time round there will be no “Bond Vigilantes”, because the Fed will own the largest chunk of the bond market.
The latest signals from the Repo markets show that the Fed is now the most important collateral owner[xvi]. General Collateral now trades below Fed Funds; and the number of securities that are trading “On Special” rather than General Collateral prices is above average. The behaviour of the Collateral Markets confirms the thesis that the Fed is moving to its holistic strategy of control, through and indefinitely extended balance sheet.
Underwriting standards are allegedly tighter; and we are led to believe that there is no fraudulent behaviour by mortgage underwriters. The Fed is going into the next potential “Trigger” point with more understanding of the last one; and a new toolkit to deal with the fallout. It may also end up owning most of the assets that would “Trigger” a normal market crisis; so in effect contagion has been avoided. The price for all this is a Fed that, marked to market, may remain insolvent until it has created the Dollars to mature the toxic assets on its balance sheet at par.
In Terminal Velocity (4), it was suggested that:
What is required is a catalyst for the Helicopter; and the Eurozone, faced with the prospect of break-up, as the Germans refuse to pick up the tab for fiscal union without a global bank run, provides the lowest fruit on the tree to be picked this summer.
Coming out of G7, all the nations involved claimed that their domestic economic agendas had been served. In particular, it was believed that consensus had been achieved in Europe on the balance between austerity and growth strategies. We would suggest that there was no such consensus. Wolfgang Schaeuble’s OpEd in the Financial Times[xvii], immediately after the meeting, summed up this divergent opinion. In principle he agrees that the European Banking crisis can be solved swiftly by European Banking Union; the devil is however in his details. He envisages a two stage process; involving national resolutions, in which the taxpayers are saved and the creditors are liquidated, coordinated by a newly formed central banking regulator. In effect, what Schaeuble calls a Banking Union a creditor would call a “Bail In”. Going forward, once it becomes clear that this is the only offer on the table from Germany, the euphoria will swiftly degenerate into a run on the weakest banks. The ECB’s Asmussen immediately pushed back against Schaeuble’s suggestions; and it is easy to see why[xviii]. The national resolutions, that Schaeuble suggests, will weaken the European banking system and sovereigns to such a degree, that the collateral that the ECB holds will be at risk. Without the central resolution authority, the ECB is at extreme risk. Asmussen’s reservations and fears were echoed by France’s Moscovici[xix]. He wishes to move immediately to the central resolution authority; and is seeking EU legal precedent to fast track this. Both Asmussen and Moscovici have overlooked the fact that the German Constitutional Court will opine on the legality of the Bailout this summer. If the French try and push this through, then they will feel the German Constitutional Court push back. Finally, there is the spectre of German elections in September. German voters, under pressure from the EU to fast track a banking union, are unlikely to support pro-European candidates. Hollande seemed determined to force the Germans away, whilst appearing to embrace them, when he called for a central Eurozone Government with a taxing and borrowing mandate[xx].
The Spanish regions have moved beyond the legal and political games at the EU level; and gone for their own version of a national resolution of their banking crisis[xxi]. This regional solution however, conflicts with the national solution put in place by the Central Government and also the terms of EU support; by confiscating defaulted properties to house the homeless. The Bank of Spain has also launched its own version of the national banking solution; which seems just as ill-timed[xxii]. The banks will be directed to go back and re-classify their 200 Billion Euros in loans that have been “restructured”. These “restructured” loans had been kept on the books as current assets, in the hope that growth would return to save them or to allow the banks to create new good assets to replace them. No such growth has occurred, so this gamble now needs to be paid for, before it gets even more costly. The implication is that many of these loans will now become non-performing. In many ways the banks are just officially catching up with reality; but in book-keeping terms they will have to account for the re-classified loans as losses. The banks will then have to provision for them and write some of them off. If they intend to keep them, they will have to raise new equity capital. The Bank of Spain is therefore forcing the national solution upon its banks, to prepare them for what it hopes will be an eventual European solution. The problem is that a substantial mark-down in these assets is now required, to reflect a reality that has not been accounted for to date. In the process of re-classifying the loans, the issues of solvency and “Bail Ins” are certain to arise.
The alert reader may have noted that the Bank of Spain has suddenly chosen to move, immediately after the regional governments have seized the defaulted properties. Clearly these events are connected. The banks thus have to re-classify the “restructured” loans on the defaulted homes that have been seized by the regions. The situation will become really interesting, when it is found that the banks have been using these loans as collateral to get funding from the Bank of Spain. This funding window has just effectively been closed. Core Europeans will remember being in this situation before with Greece (and Cyprus); and finding once again that money advanced against dubious collateral is siphoned off into private bank accounts outside the Eurozone. At this point the Germans will say “we told you so”; and put a moratorium on any future bailouts without complete political control attached. In response the Spanish people will say no; and the country will be close to defaulting on all its debts
The Bank of France has put forward its own “national” solution to the banking crisis[xxiii]; which could be scaled up to Eurozone level. The banks will be allowed to move loans off balance sheet to special purpose vehicles (SPV’s), which will not have to undergo scrutiny from the Anglo-Saxon rating agencies. Ratings will be ascribed using the Internal Ratings Based approach, which the BIS has allegedly blessed. This ratings model essentially involves the banks themselves subjectively rating their own assets. It has been used in the past, in order for the banks to avoid having to raise expensive equity capital; so it is clearly biased in favour of the banks. The whole objective of the exercise appears to be to get the paper rated so that it can be unloaded onto the ECB.
Europe is once again speaking with many voices, in different languages, all claiming to speak for the whole. It is therefore no surprise that the Pew Research Center found that anti-European sentiment was high in all countries[xxiv]. It also found that Germans are confident in the present and worried about the future; but remain confident that Angela Merkel will continue to take care of their national interests. The rest of Europe is pessimistic in the short and long-term; and has no such faith in its political leaders or the leaders from the EU.
So opaque is the whole European political and economic vista that Moody’s expects default rates to rise into Q4/2013 and then converge lower to the stable global trajectory in Q1/2014. Moody’s however does refer to this period as a “Grey Area”. It is this “Grey Area” that we envisage as the catalyst that launches “Bernanke’s Helicopter”; which then keeps the default rates in America on a stable trajectory.
It is also this “Grey Area” that has prompted the European Banking Authority (EBA) to delay all stress tests on European Banks until 2014[xxv]. Allegedly this move is supposed to allow the ECB to get up to speed on the portfolios of the banks that it will soon be supervising as the systemic regulator. The EBA tried to sound confident (and to cover its own base) by saying that this delay would:
“help dispel concerns over the deterioration of asset quality due to macroeconomic conditions in Europe”.
In practice, the ECB will actually be performing an audit of all the banks and also the EBA; to see what it is inheriting. Given that the European economy has slowed down since the last stress test in 2011, it will be interesting to see how the model applied at the last test has performed. Given that the ECB is currently embarking on this exploratory mission, it is hard to see Germany (or the ECB) signing up for a banking union, let alone Hollande’s proposed political union. In fact, the ECB audit may expose the very issues that vitiate against such unions.
Satellite images of what the ECB will investigate is provided by the data on the size of the European banking sector (below).
The two graphs (above) clearly show that the European banking sector is too large, relative to GDP, on a global comparison. Given that the European economy is contracting and credit is shrinking, this size becomes even more of a problem. It is therefore logical to conclude that the size of the European banking sector, in addition to its solvency, are now about to be addressed. To inflame the situation, a parallel political debate is raging; on whether these size and solvency issues should be addressed at the national or European level. In our opinion, this debate will be enough to get the “Helicopter” started.
“Bond Vigilantes” and “Inflation Hawks” will be expected to pounce when the “Helicopter” is visible. In relation to the “Bond Vigilantes”, we would repeat that thanks to central bank purchasing and austerity, most of the universe of government bonds to sell resides with said central banks. A massive wave of selling is therefore unlikely.
In relation to the “Inflation Hawks”, recent US import-export data shows that America is importing more deflation than it exports. America is therefore caught in a deflation spiral, but it is managing to offload this deflation at a higher level to its export partners. From a global perspective, America is hedged against deflation.
Unfortunately, it is not hedged against domestic deflation. It is in times of deflation that loan default rates start to spike. The inflation backdrop at the domestic and global levels, therefore gives great scope for the “Helicopter”.
Further evidence of domestic deflation was provided by the recent New York Fed Household Debt and Credit Report[xxvi].
The Press Release[xxvii] reported:
that households continued to improve their finances during the first three months of 2013. Outstanding household debt declined approximately $110 billion from the previous quarter, due in large part to a reduction in housing-related debt and credit card balances.
The US Consumer and the Federal Government therefore are continuing to deleverage; and in so doing are creating the domestic deflation conditions that cannot be hedged. This deleverage may improve credit scores and delinquency rates; however it simultaneously raises the probability of rising defaults. It is therefore quite reasonable to expect default rates to start rising in America also, by nature of the fact that deflation is increasing the value of existing debts. A weak economic recovery can only raise this probability. The Fed can monetize the Federal Governments debt in order to mitigate this deflation cost in the public sector. In the private sector however, the Fed must either monetize private debt or create the monetary inflation in the hands of the debtors to pay it down. We suggest a combination of private sector debt monetization and direct monetary inflation is now being followed by the Fed. MBA purchases represent the beginning of the private sector debt monetization; which we expect to expand to other asset classes. The “Helicopter” would represent the direct inflation route to avoid deflation.
In Terminal Velocity (5)[xxviii], Charles Plosser[xxix] was noted as the most outspoken Fed dissenter. He would like to take the Fed’s balance sheet down; and have the kind of conversation they were having back in 2011 when the exit was contemplated seriously. Plosser was recently on the road in Sweden, repeating this message[xxx]. Clearly, he sees the “Helicopter” and its inflationary consequences looming. The ranks of the “Hawks” have been split however[xxxi]. Fisher[xxxii], like Plosser, sees a bubble in housing; and would like to end MBA purchases immediately. Lacker also is uneasy with the Fed making credit bets on mortgages; however he sees economic weakness and falling inflation bringing more dangerous disinflation. Lacker therefore stands apart from the traditional “Hawks”, because he advocates replacing MBAs with Treasuries. It can therefore be said that Lacker in principle still believes in QE and the extended balance sheet. If the economy and inflation weakens further and housing goes into a sell-off again, it will be interesting to see if these “Hawks” change their tune.
The IMF is not ready to take the plunge with the “Helicopter” yet; and opines that the Fed’s easing by communication programme should be adopted by all developed market central banks. The IMF admits that incremental QE is not working; and if anything is creating too much exit risk. The only solution that it sees is therefore an indefinitely extended balance sheet for central banks and words to that effect also[xxxiii]. Balance sheets will thus contract via asset maturity, rather than by sales. This reasoning follows that of Michael Woodford at Jackson Hole in 2012[xxxiv], where he opined that the good work done by QE is undone by speculation regarding its unwinding. Woodford has since gone further and called for the “Helicopter”[xxxv], but the IMF is not on board with this next step at this point in time.
The IMF appears to be increasingly falling behind the times again. A study by Nikola Mirkov and Gisle James Natvik, using the central banks of Norway and New Zealand as examples, found that central banks’ actions become constrained by previous guidance[xxxvi]. The risk then becomes that they do not react swiftly enough to changing circumstances. One can see where this is going. In the short run, the Fed becomes locked into the Evans Rule. The risk becomes that it then creates inflation because the economy is actually stronger; or as we favour that the economy is weaker, but the Fed assumes that the current volume of QE is sufficient. In the latter case, the “Helicopter” will then become the default solution.
There are already signs emanating from Rosengren[xxxvii] and Bloom Raskin[xxxviii] that they have seen that the current volume of QE will undershoot. Both their recent speeches were clear that they thought that the fiscal headwinds are far greater than has been thus far assumed. Clearly, the “Helicopter”, if and when it comes, will address this fiscal drag.
The cognitive dissonance at the Fed and the policy inertia risk it implies, were highlighted by the latest views that conflict directly with Rosengren and Bloom Raskin. John Williams[xxxix] like Plosser and Fisher, also sees a stronger economy signalling the need to taper QE. The dissonance problem was clearly articulated by Bloom Raskin, in her latest speech opening remarks:
“It’s easy to be an economist who looks back on crises and crashes and tries to explain why they happened, but much harder to be an economist whose efforts manage to help stop them from happening in the first place. Economic policymaking, at its best, reflects a continuous struggle to make sure that data and explanations of such data are consistent with real experience. If we’re to engage in this struggle honestly, it’s no easy task. It involves understanding not just the reliability and signal in various data, but also questioning whether the data accords with our understanding of actual experience. So, to get this right requires many different perspectives, not just on the data but on the underlying realities the data are trying to capture.”
Everyone at the Fed is well intentioned, but they are not omniscient. They are also human, which means that they like to see things that support what they have previously committed to saying in public. A man (or woman) with a hammer, only sees nails.
As a consequence of the Fed’s cognitive dissonance, the markets can become dissonant. A recent Bloomberg survey found that the majority of those polled saw two more years of US economic growth. It seems more likely that those polled actually substituted the question, to become “How long do you see the Fed engaged in QE?” Clearly the Fed is expected to be engaged for two more years, based on its communications and economic projections. Recent weak data has reinforced this perception, so that the Equity market has been able to break through its previous highs, even as the headwinds blow stronger. This “Risk On” behaviour then causes the “Hawks” to scream “bubble” and “taper”. The “Doves”, who are looking at the slowing data, however worry that they are not being stimulative enough. Both camps are well intentioned and right; but if their timing is wrong, the results could be disastrous. It would be under these disaster conditions that we would expect Bernanke to stay on as Fed Chairman and fly the “Helicopter”, as both “Hawks” and “Doves” would be framed as not having the right stuff. To let them off the hook, Bernanke would frame the issue as them not understanding the threat posed by Europe.