Age of Wisdom, Age of Foolishness, Part (5)
Age of Wisdom, Age of Foolishness (4) “End of the Cycle” observed “the new seeds of global conflict developing in what Professor Peter Turchin[i] has referred to as ‘Rich, Overeducated Elites’[ii]; attempting to prolong the duration of the current Fin de Siècle, by what is termed in the vernacular as ‘kicking the can down the road’”. It was explained that national policy makers have developed the political skill of exaggerating external existential threats in order unify the disparate factions within their own countries. The Environment was presented as the ripening lowest fruit on the tree; to be plucked and presented as the next existential threat. By way of reference, to time-stamp this “ripening”, three key signals were recorded last week.
China is currently undergoing its own “Tale of Two Cities”; in which corrupt “Rich, Overeducated Elites” are on trial. To balance this explosive force, a cohesive force is therefore required. The declaration of the “air defence zone” in the East China Sea conveniently supported this cohesive force. It is also a blessing to China’s perceived enemies, by providing cohesive forces within their own polities. The immediate American projection of force, with the “rolling thunder” of the old B-52 “Cold Warhorse”, corresponded to the hoof beats of the cavalry charging in to save the day[iii].
Japan, the new good guy in this regional conflict, also capitalised on the opportunity presented by this existential threat; to force through legislative changes that put it on the path to conflict. The new Secrecy Law which creates the cover to militarize by stealth was rushed through; and in addition power was concentrated in the Prime Minister’s hands with the creation of a National Security Council[iv]. War making now becomes the prerogative of the Prime Minister and his National Security Council; as the balancing pacifist influence of the Parliament is willingly legislated away in the face of external threat.
The nebulous issue of the Environment coalesced a little further; into a more granular topic over which the lines of global debate can degenerate into a conflict. The United Nations Framework Convention on Climate Change’s recent meeting in Warsaw was an event that created the clear lines of future conflict[v]. The Developed Nations were observed to be stalling on financial commitments to support their Developing partners to reduce Carbon emissions. China and India then broke from the ranks of their Developing Nation partners; and scaled back their own commitments to meet emission cutbacks[vi]. All this occurred against a headline news story which revealed that America has been wildly underestimating the volume of Methane it has been creating[vii]. Methane is by itself a greater contributor to Global Warming than Carbon Dioxide by several magnitudes. The most visible backdrop to the whole debate was however Typhoon Haiyan in the Philippines; which showed the devastation that occurs when Developed Nations and Emerging Powers fail to agree on their environmental obligations[viii].
On the home-front, further data was released to provide context for the Federal Reserve’s attempts to preserve its balance sheet and survival. Cheerleaders, with an axe to grind, continued to opine the housing recovery. The Lender Processing Service (LPS) observed delinquencies continuing to fall in October[ix].
Freddie Mac reported serious delinquencies at their lowest level since 2009[xii]. Enthusiasm was however tempered; as even Zillow had to admit that negative equity is a phenomenon that will remain at elevated levels in the new normal housing market[xiii]. Zillow therefore accepts the “Tale of Two Cities”. The “Wealthy City” exists as a consequence of the Fed’s policies in alleged response to the tale of the “Poor City”. The “Wealthy City’s” existence is contingent upon the existence of the “Poor City”. Speculative bidding in hot property markets, which appears to drag up the national price level, can thus co-exist alongside a continued slide in specific regions[xiv]. Within this dynamic equilibrium, there is a shifting pattern of housing risk emerging. Banks are seeing improving home equity reach levels which cannot improve further because of the weak economic recovery. They are also seeing delinquencies starting to rise again; as a consequence of the fact that the ten year anniversary of existing loans is now obliging the borrowers to start amortising their mortgages[xv]. Interest payments are rising because of the “Taper” and combining with the amortization schedule to make mortgages delinquent. It would seem that borrowers cannot afford to pay the principal amortization balance in addition to the rising interest payment. The banks have therefore decided to foreclose via the normal process, rather than through Short Sales; and then to auction the foreclosed properties[xvi].
Investors who wish to rent these foreclosed properties are bidding at auction[xvii].
Banks are therefore transferring the risk to investors; and the risk is now associated with the ability to pay rent rather than to pay a mortgage. The Yield Curve continues to steepen, which has further compounding effects. Firstly, refinancing is choked off. Secondly, delinquencies rise as borrowers are unable to refinance at higher interest rates. Thirdly, the banks pull the trigger and foreclose, transferring the risk to investors at auction. The interest rate dynamic is however not done. Investors may be cash rich however they still require an attractive comparative rate of return on their investment. In a steepening Yield Curve environment, they must then derive a higher rate of return. Rising interest rates reduce the capital gain component of the return therefore investors must rely on rising income. Investors will therefore be looking to raise rents. It now remains to be seen, if renters will have the ability to pay higher rents. Borrowers have been forced into renting because the banks have a negative view of their ability to pay debt; so it seems unlikely that landlords will have much joy either. The banks perhaps understand this situation, better than investors, because it is the banks in combination with the Fed who are driving interest rates higher.
Age of Wisdom, Age of Foolishness – 1913/2013 “End of the Cycle” suggested that the Fed had no intention of reducing the Interest Rate Paid on Reserves (IOR); and was in fact just about to actually pay an increased risk premium to the banks for facilitating its increased balance sheet. Last week, in order to justify this raising of the risk premium (aka the “Taper”), the banks declared that they would have to respond, to a reduced IOR, by charging depositors a fee to deposit their funds[xviii]. Depositors would then withdraw deposits and banks would be forced to shrink their lending books; and presumably the economy would stall again. Having challenged the case for a reduction in the IOR, the way is now clear for it to rise. A higher IOR has been framed as the basis for banks increasing Reserves and hence their balance sheets. The banks therefore understand that interest rates are about to be ratcheted higher, since they are the ones doing the ratcheting. They are therefore deftly transferring all risk, associated with this ratchet, onto private investors and the Fed. The Fed is therefore being forced (by the banks) to take the political decision to support private capital at the expense of “Main Street”.
Charles Plosser’s resistance to the Fed’s strategy creep into politics, via its expanded balance sheet, was clearly articulated in what can be termed as “Plosser Doctrine”. “Plosser Doctrine” was articulated at the Cato Institute’s 31st Annual Conference on Monetary Affairs by its author; and has four main principles:
In his own words[xix]:
- “First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;
- Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;
- Third, limit the Fed’s discretion in monetary policy making by requiring a systematic, rule-like approach;
- And fourth, limit the boundaries of its lender-of-last-resort credit extension and ensure that it is conducted in a systematic fashion
These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and, at the same time, they would make it easier for the public to hold the Fed accountable for its policy decisions. These changes to the institution would strengthen the Fed for its next 100 years.”
“Plosser Doctrine” is now steaming towards “Yellen Doctrine” on the high seas of liquidity.