The Bank for International Settlements (BIS) was observed preparing the markets to deal with increased volatility in Terminal Velocity “Normalization?” Its recent communications have now clarified the economic implications of this greater volatility. Rising real yields will exacerbate debt costs in those indebted nations which are unable to grow fast enough to service their debts[i]. Cutting debts will further slow economies and produce a negative feedback loop; as has been seen in the weaker European economies. Japan and the UK, the most indebted of the Developed Economies, are particularly at risk from this negative feedback loop. It sounds as though the BIS is calling for a major rethink of Austerity. Before the “Inflationists” see this as the green light to embark on more monetary stimulus however, the BIS opines that QE has run its course[ii]. Policy makers are advised to reform the structure of their economies to stimulate growth.
As a postscript to Bernanke’s last FOMC Press Conference, the BIS is underlining the message that the Fed is moving to normalize interest rates to create conditions for private capital to re-engage with the capital investment process. Capital investment will however be held back by dysfunctional policies, so the ball has been thrown back to the politicians. Sadly the politicians have believed that QE lets them off the hook. QE has rewarded political inaction and partisanship; and has reinforced this behaviour. The liquidity punch bowl has now been removed from both speculators and policy makers.
The Fed will hold an open meeting on Basel III compliance on the 2nd July[iii]. The FDIC and OCC (which is a board member of the FDIC) must also vote on this Basel III compliance; but they have been less pro-active than the Fed. It is clear that the Fed wishes to accelerate the process; and be in control of it. Turf wars may threaten this important piece of systemic risk management.
Bill Dudley chose to use the platform of the BIS to try and set limits to the sell-off in the Treasury Bond Market; and hence the Normalization of the interest rate term structure[iv]. He also confirmed the thesis being developed in the Terminal Velocity series, which suggests that the expanded balance sheet and “Taper” are macro-stability tools in addition to monetary policy tools. We have said that:
“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.”
– (Terminal Velocity “Minds and Hands of the Joystick”)
“This expanded balance sheet will be used to do microeconomic monetary operations across asset classes and maturities. Clearly this strategy is both a monetary policy and macro-stability tool. The application of the Basel III rules on capital adequacy and Bloom Raskin and Plosser’s rules on risk weighting and leverage ratios will facilitate these monetary policy and macro-stability objectives.”
– (Terminal Velocity “Normalization?”)
This confirmation signal came from the title of his speech,
“Why Financial Stability is a Necessary Prerequisite for an Effective Monetary Policy”.
Dudley supports the recommendations of the BIS[v]; and also those of his colleagues Bloom Raskin[vi] and Plosser[vii], who say that the banks need to raise more capital. He also concurs with Bernanke’s original thesis about bubbles developing when speculators “reach” for yield at the “Zero Bound”; which he delivered at the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago, entitled Monitoring the Financial System[viii]. Dudley specifically highlights this risk as a condition of a prolonged period at the “Zero Bound”. Dudley however gently pushed back against the departing “Lame Duck” Chairman, who we described in Terminal Velocity “Gatsbied”, in a far more subtle manner than James Bullard[ix]. Dudley’s dissention is both subtle and profound. For him, the “Transmission Mechanism” remains broken. This broken “Transmission” is the principle source of risk; and the reason why the economy has not recovered. Until it is mended, the application of conventional policies and yardsticks cannot be assumed to be appropriate. He therefore takes issue with the sharp rise in yields and steepening of the yield curve. He even illustrated this point by opining that the Taylor Rule no longer applies. We think that Dudley is confirming our warning in Terminal Velocity “Normalization?”, when we said that:
“…..America can take the pain of transition to a Normal Yield Curve environment (or so the Fed believes). This means that the upward move in interest rates should be smaller than it would have been in a rising inflationary environment. If this is the theory behind the Fed’s move, we think it is dangerously simplistic given the Deflationary environment that is emerging ……. In a Deflation, low interest rates are at least as dangerous as rising interest rates in an Inflation.”
Dudley is worried about the impact of Deflation on debt; which is also a topic that the BIS warned on earlier in the recent communiques from Basel. He is therefore trying to set limits to the level of real interest rates, by talking bond yields down.
What we found most interesting about Dudley’s speech however, was a passage that runs parallel to our thesis in Terminal Velocity “Gatsbied”; which states that QE pulls economic growth from the future and creates a “Black Hole” into which equity market valuations converge and fall. He opined that:
“Lower interest rates may make financial conditions easier, lifting wealth, and encouraging households to shift spending from the future to the present. But when the future arrives, spending may then be lower as a consequence.”
Which sounds very much like:
“Observers talk in terms of Over-Capacity; but we prefer to look at this more as demand being pulled forward from the future, so that there is less aggregate demand available in the future for subsequent economic recoveries. Out there on the historic timeline continuum there is a Black Hole, where growth should be”.
(Terminal Velocity “Gatsbied”)
We like the way Bill Dudley says it better; because it seems less distressing! We have to call him out however on the “Broken Transmission Mechanism”. We would suggest that the reason it is broken is actually the “Black Hole” itself. Simply put, we have reached the convergence point at which there is no aggregate demand in the present, because it has all been pulled from the future into what is now the past. The “Broken Transmission” is actually the key signal that we have reached this point. Dudley is being disingenuous and leaving the door open to all sorts of policy actions, including the “Helicopter”. We can empathise, because he will be left behind to deal with the problem long after Bernanke leaves in 2014.
Demographics Versus QE
What Dudley is saying about growth was put into context in a very interesting piece by Research Affiliates[x]. Their thesis is that aging Developed Economies lose their growth dynamic as the aging majority becomes a net drain on economic resources.
From their perspective, the real policy challenge is to make this greying majority more productive, so that they can be a growth contributor. QE does not achieve this, in their opinion; and in fact can make things worse when applied overzealously. We would suggest that overzealous QE has pulled what remains of the greying demographics’ driving power forward; and also wasted it in leverage and speculation. The Fed is now trying to prevent further deterioration in these fundamentals, by creating a term structure of interest rates that promotes investment and growth in the future. This adjustment is not without cost; as observed in the recent violent move in long term interest rates.
The violent back-up in Treasury Bond yields has affected the Fed financially as well as operationally. The Treasury maturities that have sold off the most are the ones that the Fed has been most active in purchasing[xi].
This signals that the Fed is sitting with some serious mark to market losses. In Terminal Velocity “Goldilocks Economy and the Three Bear Markets” it was suggested that the Fed would use its balance sheet to smooth the volatility of transition to a Normal Yield Curve. This smoothing implies a readiness to take losses. The recent Treasury Bond price action however, suggests that this smoothing has not been successful. If anything, the Fed has actually exaggerated the price action and increased the volatility, by being prepared to pay up for Treasuries on the one hand and calling the “Taper” on the other.
It is therefore of no surprise that Fed speakers are now trying to arrest the rise in yields. What is surprising is that these speakers are not FOMC Members. Communication policy has become a free for all; which implies that the Fed is in crisis. Richard Fisher, who earlier in June called the end of the thirty year falling trend in yields[xii], was the first to blink; and called the bond bears “Feral Hogs” who needed to be slaughtered[xiii].In principle however, Fisher agrees with the “Taper” so his ability to slaughter the “Feral Hogs” with words is limited. Kocherlakota is as usual hoisted by his own petard. He is the most dogmatic of the Fed Governors, in that he sticks doggedly to a view; and then abandons it late to take up the opposite view that he then clings to with the same enthusiasm. This has made him a late convert to QE, which now makes him an anachronism again in this new “Taper” scenario. To protect his reputation, whilst also supporting Treasury Bond prices, he opined the need for the Fed to address its communication strategy to the grey area when unemployment is between 7% and his Kocherlakota Rule target of 5.5%[xiv]. This grey area is his “Taper” zone; and requires careful wording. He followed up with an interview on CNBC, which made it clear that he believes that the “outsize” negative reaction of the Treasury Bond market to the “Taper” was a function of this poor communication[xv]. This implies that he is still therefore a full-on buyer of Treasuries at the current level of Unemployment. Jeffrey Lacker got in on the act of talking out of class; and reiterated that the “Taper” represents easing at a slower pace[xvi]. He did nothing to end the volatility however; and actually seemed intent on making it worse to prove his own point[xvii]. It seems that having harboured a grudge against QE, throughout his term, he was finally taking a sadistic opportunity to comment on the retiring Chairman. Dennis Lockhart, another non FOMC Voting Member, made up the hand by repeating the mantra that the markets had misunderstood Bernanke[xviii]. Jerome Powell also opined that the spike in interest rates had been oversized[xix]. At least Powell is an FOMC Voting Member. Bill Dudley succinctly explained what had just happened; when he opined that the “Taper” is still an ease, the balance sheet will remain extended indefinitely and a real tightening is a long way off[xx]. Taken together, Dudley’s comments normalize the Yield Curve and set a verbal limit on how positive its slope can be at this stage. Jeremy Stein ended the remedial action by reiterating that the “Taper” was data dependent; and that technical factors such as convexity sellers and leveraged forced sellers had exaggerated the price action[xxi]. He did suggest however that the Fed may wish to clarify exactly which data was more important than others, to prevent the markets becoming even more volatile on economic release days. Most of this was ignored by the market, which instead chose to focus on his hint that we will see the “Taper” in September.
All this remedial action by the Fed had the desired effect of halting the rise in yields almost as abruptly as it began. The Five Year Note Auction was a blow out and drew a line under the fall in Treasuries[xxii]. The “Bond Vigilantes” have therefore once again done the Fed’s bidding, whilst imagining that they are independent agents; and adjusted interest rates to where the Fed would like them to be at this point. Bernanke has successfully deflated the Risk Asset Bubble he saw developing in May; and moved to Normalize the Yield Curve, with relatively little pain except for those he wished to punish. Bernanke’s victory was signalled when the Bond Gurus (and his most vociferous critics) Bill Gross and Jeffrey Gundlach called the end of the Bond Market sell-off[xxiii]. All this remedial action by the Fed and the Gurus is as overdone as the market reaction to the “Taper”. It just adds to the volatility. The Fed and the Gurus may find that too much talk makes people worry about the need for it. If things are okay, then why not leave it to normal price discovery to dynamically find its equilibrium level? At the “Zero Bound” there is no such thing however, so prices can go wherever he who speaks loudest wants them to. The Gurus and the Fed are talking their books; if the markets continue to sell off they have wasted their breath.
The Fed may find that it has not only wasted it breath but also undermined the whole notion of the Communication policy tool.
If the aging demographic vector is for real, then this implies that the declining Labour Force Participation Rate is also being driven by it. It logically follows that the Fed’s QE exit target rate for the Unemployment Rate will be hit by natural attrition from this aging demographic. The Fed will then find itself compromised once again. A secular decline in economic demand from this demographic will appear as a statistical trigger for the QE Exit. The Fed will then find itself exiting in an economy that is already in secular decline. Worse still, speculators who are focused on the Unemployment Rate will have started to drive up interest rates well in advance of the exit target threshold being hit. There will therefore be an inherent economic headwind from the markets, pushing down on the secular demographic decline, which then get reinforced by an official Fed tightening. We can now see why Kocherlakota is so worried about the grey area in the “Taper” between an Unemployment rate of 7% and 5.5%. We can also see why Jeremy Stein opined that some economic indicators are more important than others for the QE Exit. The Fed has once again talked itself into a corner. The Israelis have developed a pragmatic approach to decision making, in which they say “Don’t tell me, show me”. A Fed Policy that shows and doesn’t tell, may well be the best way to go. Unfortunately, the Fed only tells; but it will be forced to show soon.