Terminal Velocity (11) – “Getting Real Interesting”

Written by , KeySignals.com

In terminal Velocity “Minds and Hands”, the threat from the debt crisis becoming amplified by deflation was introduced into the narrative leading up to Jackson Hole. It was observed that:

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”.

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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 addition, it was noted that the fall in Federal Government spending was also creating a growth headwind. The Fed’s Rosengren and Bloom Raskin were on the record as emphasizing this risk. It was observed that:

There are already signs emanating from Rosengren[i] and Bloom Raskin[ii] 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 road to Jackson Hole therefore has three lanes:

  1. The “Hawks” Tapered Fed Balance Sheet Lane
  2. The “Doves” Deflation Lane
  3. The “Doves” Fiscal Drag Lane

The conflicts between travelers on the “Hawks” and “Doves” lanes are creating cognitive dissonance within the Fed, which is amplified by the markets. Kocherlakota is a fellow traveler on the Deflation Lane. His latest comments confirm his belief is that US real interest rates are too high[iii]. The Fed therefore, has scope to do more bond buying to lower yields to catch up with the fall in inflation.

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The subject of real interest rates is also a critical global issue. Emerging Markets have a systemic inflation problem compared to Developed Markets. Real rates of return are higher in Developed Markets, even though they appear to be in recession. Capital has thus abandoned Emerging Markets to seek higher real returns in Developed Markets. The Global Rebalancing that Developed Market policy makers have called for is now happening; but not in the way they envisaged. It was hoped that Emerging Markets would open their economies to products and services from the Developed Markets, to rebalance the global economy. What has happened in practice is that capital has moved from Emerging Markets to seek higher real returns in Developed Markets. Capital has thus chased financial assets offering high real yields. Unfortunately, capital has not chased growth opportunities in Developed Markets’ real economies, because they are in recession. Developed Markets have thus become a black hole for capital. Capital appears to be going in the wrong direction. It appears to be chasing recession and running away from growth. It is actually chasing real return and avoiding inflation. As it leaves the Emerging Markets, they will experience falling growth and falling inflation. Deflation will be framed as the greatest threat to the global economy at Jackson Hole. The compounding impact of this deflation on debt will then be expanded upon, to roll back the case for fiscal austerity; and to promote the case for the “Helicopter”.

Currently, the greatest minds in economic analysis are struggling to come to terms with the real interest rate paradigm[iv]. Applying their old rule of thumb, that ignores real interest rates, the current behaviour of the Gold/Silver Ratio should be negative for US Equities; as we see in the graph below.

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Applying the new rule of thumb, in relation to real interest rates, high US real interest rates are attracting capital flows. The US Dollar therefore rallies and Gold falls. Holders of US Dollars now need to put them to work. Since the Fed has collapsed yields and yield spreads in nominal Dollar terms, investors will not drive them any lower on a valuation basis. Bond investors now make their return by earning real income, rather than by chasing capital gains, at this point in the interest rate cycle. To find capital gains, investors must turn to spread product and equities. The divergence of the S&P 500 from the Gold/Silver Ratio (and even the real economy) is therefore explained by real interest rates.

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A similar explanation can be used to explain the break in the correlation between the S&P and TIPS. It used to be that the S&P was an inflation hedge; now it is a proxy for flows into the US Dollar looking for real yield plus a call option on rising inflation.

The Bank of Korea Governor, Kim Choong Soo has had no problem understanding the real interest rate paradigm; as have many other central bankers in Emerging Markets, who have recently found that life at the “Zero Bound” has moved from hot money inflows to secular long term outflows back into US Dollars[v]. Capital is already flowing back to the US Dollar Zone, even before the Fed has begun to normalize interest rates. Mr Kim has become very alarmed at what will happen when US interest rates start to rise, as the Fed exits its QE programme. Suddenly the Emerging Markets love American QE and wish it to continue indefinitely. This observation underscores the thesis that the US Dollar remains the World’s reserve currency; and that the Fed has become the World’s Central Bank. When the Fed exits therefore, it must take into account the global impact of its actions. We are back to where we were leading up to 2008. When the Fed tightens, the whole global economy has a recession. It is with this in mind that we believe that the Fed will be inclined to maintain an expanded balance sheet indefinitely, until the global economy has rebalanced itself into an integrated sustainable entity.

Confirmation that the Fed is the de facto World’s Central Bank has been revealed in analysis done by Zero Hedge of the flows of funds since QE began[vi].

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The analysis shows that cash held by foreign commercial banks in the USA has risen after each subsequent round of QE. Traditionally this has been viewed as a case of foreigners dumping their unwanted Dollars; however this is clearly not the case. The foreign commercial banks have remained owners of their Dollars and have used them to earn risk free interest.

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With the lack of global growth opportunities and given foreign regimes’, such as the Eurozone, habit of confiscating capital rather than paying their debts the USA has been viewed as safe haven for capitalists. The “US Bail Out”, signaled the willingness of the Federal Government to put the interests of private capital above that of its taxpaying citizens. The Federal Government does not fear the backlash from the same taxpayers, who become voters periodically in the electoral cycle. European political leaders are far more in fear of their voting taxpayers; however the creation of the Eurozone super-state is attempting to cut this link with democracy. Thus far the battle between the EU and the voters remains undecided. America has strongly advised the EU to adopt a “Bail Out” mentality, to smooth the transition away from democracy; however thus far it has not been adopted. As a consequence, the Dollar is viewed as a safe haven. If Europe were to adopt this “Bail Out” mentality, the next step would allow the ECB to start monetizing debts the same way that the Fed does. It is this pro-capital feature of the USA that has kept demand for Dollars healthy. The Fed’s willingness to pay interest on Excess Reserves is one source of this pro-capital behaviour. The Excess Reserves are in effect the US Dollars held by the foreign commercial banks. They are in excess because the volume of QE is far in excess of that needed to finance the real economy of America. The other source of this pro-capital behaviour is the willingness of the Federal Government to give private capital preference in the capital structure of the US economy over taxpayers. In effect, private capital owns the US economy and not its taxpaying citizens.

The global obligations of the Fed, by nature of the primacy of the US Dollar have not been lost on Bill Dudley and James Bullard. Dudley tentatively addressed the issue of the exit from QE in his latest speech[vii]. He emphasized that this is an event that markets will initially overreact to; and that this negative overreaction will be wrong. He also very swiftly killed off Plosser’s ideas of returning to the exit discussion circa 2011[viii]. As Plosser had feared when he suggested this strategy, the Fed’s balance sheet has become too big for it to be applied. Dudley confirmed that Plosser’s strategy is an anachronism; and suggested that the exit needed re-evaluation. He hinted that this exit will be via asset maturity, rather than by asset sale. This would support his warning against an overreaction by the markets when the time comes for the Fed to announce the exit. Dudley was even more cryptic, when he claimed that he truthfully didn’t know if the Fed’s next action would be asset purchase increase or decrease. It is therefore becoming clear that the exit is a long way off; and will be achieved via assets rolling off, rather than getting sold into a market that is anticipating heavy sales. The debate in the FOMC over the exit seems to have been protracted, based on the recently released minutes[ix]. Plosser’s attempt to get the baseline back to 2011 was clearly recorded in the minutes; as was Bernanke’s response. The Chairman directed the members to go away and create some exit strategies, which can then be debated and used to craft an exit strategy when the time comes. Commentators will now focus on the word “exit”; and will assume that it is imminent. Speculators will then begin to discount it, so that its negative feedback through falling asset prices and rising yields becomes a reality. Consequently, the Fed will find itself back in the same position it was in after each successive iteration of QE was assumed to be over. Despite what people like Bullard, Evans and Rosengren say about the efficacy of QE, it has an in built tendency to be self-defeating each time the word exit occurs. This is why we think that the “Helicopter” is becoming a viable alternative. John Williams added to the confusion when he recently reversed his position on the infamous “QE Taper”; by announcing that subject to data the balance sheet could be expanded in the future[x]. This cognitive dissonance at the Fed has now become contagious for the markets. The US Primary Dealers have admitted that they are totally confused by it all[xi]. These individuals are binary thinkers, so nuanced communication strategies do not compute. When in doubt they sell first and ask questions later. Consequently, yields rise and risk asset fall in price, so that the Fed ends up with an unwanted economic headwind. The latest posted US Mortgage Interest Rates are a classic example of this phenomenon.

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They are also an example of how high US real interest rates are getting. With inflation rates falling below 2%, the real cost of carrying these mortgages in a weak economy is high. This high real cost eats into salaries, so that there is less money available for consumption. If the buyers have chased the offer side of the market, they will also have bought themselves a very expensive property which they cannot afford to own. As house prices rise, they have rising equity which creates the illusion of affordability. When the real rates of interest sap consumption and growth, the economy will then fall back into recession and negative equity will be back.

Perhaps the most important thing about Dudley’s speech was its context. Firstly, it was delivered to the Japan Society. Second, it was named “Lessons at the Zero Bound: The Japanese and U.S. Experience”. Third there was its content; which was rich in analysis and highly critical of the monetary policy of both the BOJ and Fed.  The two central banks were redeemed only by the fact they learned from their mistakes; and are now correcting their mistakes with forceful and strongly communicated monetary policy actions. This speech was perhaps the most humble that has been heard from any Western central banker in history. In the traditions of Japan it was both deferential and self-deprecating; the only thing Dudley did not do was to bow at the waist. Dudley was signalling that the both the BOJ and the Fed have learned from each other; and have allegedly got their act together. They will not undermine all this good work by premature exits from the policy decisions they have made; in addition these policy decisions will be implemented to the full until they are unequivocally successful. Both institutions wish to put the phenomenon of the Lost Decades firmly behind them. Dudley made it clear that deflation was the curse of Japan’s Lost Decade; and that the BOJ exited before deflation had been eradicated. Clearly, this time around the BOJ and the Fed do not intend to make the same mistake. Finally, it was significant that Dudley appeared to be speaking critically about Japan with the full authority of Japan. This is another first for a central banker; and evinces the kind of global cooperation that has just been taken to another level by the BOJ and the Fed.

The Japanese theme was followed on the cover of the Economist; which once again turned out to be a classic contrarian signal.

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The reader should understand that recent activity, from the Fed and BOJ, was designed to focus market attention on Japan; and the lessons it holds for all late stage developing economies. Having focused attention on Japan, it was therefore not surprising to see Japanese capital markets go into a volatile crisis as the markets tried to rationalize what they were being told. As was the case with binary Treasury Bond traders, binary JGB and Equity traders sold the confusion.

Bernanke appeared to echo the warnings of Dudley, about the deflationary consequences of ending QE prematurely; in what was a generally unrevealing prepared statement for his Congressional Testimony[xii]. As Dudley had anticipated, markets overreacted; especially the Japanese Equity Market, which put in a major top. Having listened to Bernanke’s testimony, the markets decided that his fears of a sell-off, from premature QE exit, should be taken as the trigger to create this situation. The Japanese bond market is selling off to create the higher real yield that is needed to sustain investment flows. Since the BOJ has targeted 2% inflation, real yields must rise above this target. The markets have overlooked the fact that there are no signs of Japanese inflation; and have instead focused on the central bank guidance.  As Michael Woodford opined at Jackson Hole in 2012, the discounting of the Fed exit will undermine all the benefits of QE[xiii]. Central bankers are now finding out that guidance has its drawbacks. Guidance is only of real value when there is a crisis; and the markets demand firm action. Having triggered the crisis, the Fed and BOJ can now guide more strongly.

James Bullard had an even more interesting international agenda than Dudley; however it also played to the Japanese and Lost Decade themes. It is becoming apparent that his new mission is to convince the ECB to embark on its own “aggressive” QE programme. Bullard’s recent speech in Frankfurt, the home of the ECB and the spiritual home of hard money, warned the Europeans that they faced the scenario of Japan’s Lost Decades if they did not move on “aggressive” QE soon[xiv]. It would be inappropriate for Bernanke or Yellen to talk about the European economy in this way; and to give policy recommendations. Bullard has been tasked with the job; since he is out of the running for Bernanke’s job. Assuming Bernanke leaves and Bullard is successful, he is likely to be rewarded with the Vice Chair. Bullard is chosen for the most delicate communication issues; when Bernanke wishes to be more overt and less reliant on the covert John Hilsenrath. Bullard was the first Fed member to break the news on QE2, so he is well qualified to engage with the ECB. If he is successful, the ECB and the BOJ will be doing some heavy lifting, so that the Fed does not assume all of the risk. After his appearance in Germany, he was in London; where he made it clear that deflation is his real concern[xv]. He will not sanction an end to QE until he sees inflation back on an upward trend.

In Terminal Velocity “Helicopter Take-off”, the national accounting gimmick, applied by the Bureau of Economic Analysis (BEA), to boost the value of the technology sector in GDP calculations was explained[xvi]. In his latest speech to the Graduates at Bard College, Ben Bernanke chose to comply with the new “optimistic” accounting rules. Rather than talk about the great deflationary pressures that technology and innovation bring to an economy, through productivity and scale effects, he positioned them as growth drivers. When the new GDP figures are released in July, he will also have some data to prove his point.

Michael Woodford[xvii] and Adair Turner[xviii], the principle advocates of the “Helicopter”, have begun to push the debate further into the public domain as Jackson Hole approaches. They were first observed in Terminal Velocity (4) – “Bernanke’s Helicopter Landing at Jackson Hole”[xix]. Most recently they both appeared in an interview on Vox with London Business School’s Lucrezia Reichlin[xx]. Vox presents itself as a “Research-based policy analysis and commentary from leading economists[xxi]. It would seem that these two economists are joined at the hip, at least in relation to the subject of “Helicopter Money”. In their latest double-team outing, they were careful to compare and contrast their styles. In effect there are two “Helicopter” prototypes on the drawing board.

Turner’s is “overt”, in his own words. In his version there would be a direct fiscal transfer from the Treasury to individuals. This transfer would be financed by purchases of new Government Debt by the Central Bank; with the accompanying clear statement that this purchase was permanent. There would be no doubt that the money supply had been expanded, by the permanent creation of new money.

Woodford’s Prototype” is “indirect”. The fiscal transfer from the Treasury is the same; however it is accompanied by the Central Bank announcement of purchase of new Government Debt and a commitment to keep buying to maintain a Nominal GDP Target. Woodford’s scheme therefore preserves the charade that the Central Bank is independent. Turner wants to destroy this charade deliberately, to make consumers clearly understand that the creation of new money is permanent. Woodford, in 2012 opined that QE didn’t work because speculators anticipating its reversal undid its benefits[xxii]. After Bernanke’s Testimony, this observation is now being validated by market behaviour. Turner has therefore built on Woodford’s assertion; and made it impossible to discount the end or reversal of QE. Turner in fact wants markets and individuals to discount the inflationary impacts of permanent money creation. The latest actions of global markets are playing into the hands of Turner, just in time for Jackson Hole.

The appearance of the two “Prototypes” is nuanced. In the traditions of Behavioural Economics and Nudge Theory, Turner and Woodford wish to frame the debate (and hence prime public opinion) in a way that already accepts “Helicopter Money”[xxiii] in principle. The audience is then prompted to decide which form of “Helicopter Money” it prefers, “overt” or “indirect”. In effect, the public is being asked which “Helicopter” would you like; rather than do you want the “Helicopter” or not.  In the same Behavioural Finance traditions, markets are now creating the simple emotional sell-trigger to anticipate an exit from QE, on hearing that exit conditions are being discussed. Turner and Woodford will therefore have a receptive audience; which accepts their “Helicopter” once the sell-off in markets is under way and speculators are looking for a response from the policy makers to arrest the decline.

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Both “prototypes” are intended to have the same result, of placing money in the hands of those who need it; and will spend it rather than save it. As the graph above shows, the experiment with monetary policy to date, which has relied upon the fractional reserve multiplier of commercial banks, has been good for financial assets and bad for the labour force. If the equity market is supposed to be a signal of future economic activity, then the lag period of this activity has now reached a point that challenges all prior beliefs. More QE simply increases the divergence between “Wall Street” and “Main Street”; and increases the systemic risk of the former which then knocks onto recession in the latter. Woodford and Turner wish to narrow the gap, by diverting liquidity to “Main Street”.

The Eurozone banking crisis took one more step towards reality, when senior bankers in Portugal began to opine that the equivocation over national or central bank resolution was spreading some contagion their way[xxiv]. They specifically referred to Greece and the “Bail In” model as the source of this contagion. Periods of economic crisis are often coincident with the scheduled meetings of NGOs and think tanks that are supposed to sketch out informal global solutions. As recent history shows, “Change” comes from crisis. The Eurozone will clearly be at the top of the list when the Bilderbergers meet in Watford on June 6th, to discuss the current threats and challenges to the global economy[xxv]. The relationship between Britain and the EU and also the survival of the Eurozone will be critical issues. It has been leaked in advance that the press will be given greater access to the meetings. Clearly this is not going to be your grandfather’s, or your father’s Bilderberg.  If the Eurozone was going to blow up, this would be a good time; leading up to Jackson Hole and German parliamentary elections later in the summer. Perhaps James Bullard will be there too, to execute his next “aggressive” move on the ECB.

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The Eurozone economy has also mutated. The Core, especially France, is weakening and the Periphery has held up. The sagging economic weight of the Core is therefore the new source of risk. France is still holding out for a move similar to what Germany and France did in the past, when they were breaking Debt-to-GDP limits. In the past, they simply broke the rules because it suited them. This time around however, having forced austerity onto the Periphery it would be impossible for them not to apply it to themselves. Weidmann called out France to continue with reform; so it is clear that Germany intends to maintain discipline and lead by example[xxvi]. France is looking for any excuse to deviate; therefore it has made a pact with Italy to break austerity. A clash between France and Germany over European leadership is looming.
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