Terminal Velocity (12) – “Normalization?”

Written by , KeySignals.com

In terminal Velocity “Getting Real Interesting” and “Real Headwinds”, the spectre of American Deflation and rising real interest rates started to loom over the global economy. This can be understood as all the QE that has poured out of the American capital markets finally returning back home in search of rising real yield.

Source: FRB
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Recent Federal Reserve Board data (above) has shed light on this capital flow. Capital leaving foreign markets weakens the financial institutions of the countries that it leaves. Capital also heads for perceived security. The implied Federal Guarantee of the US domestic banks therefore acts as an attractor for this capital.

Source: Record of Meeting of the Federal Advisory Council and the Board of Governors Friday, May 17, 2013
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American banks also embraced the process of recapitalizing their banking system far earlier than their global peers; which adds to their attracting power. Foreign banks are perceived as having another shoe to fall in terms of a credit event, which will lead to their recapitalization. Capital leaving global peers therefore makes them even weaker by comparison with American banks. As a consequence, there is a liquidity shortage in foreign banks with branches in America. Foreign banks therefore must pay a premium to issue short term bank funding liabilities, whereas American banks can rely on a healthy deposit base.

There have been no inflationary consequences of this capital flow so far, because it has not yet hit the real economy.

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The latest US Personal Consumption and Expenditure data confirmed that this capital flow has avoided the real economy and evaded American workers. Personal Income has basically flat-lined during the recovery. QE has abandoned the real economy and gone into financial assets, where it can earn higher real rates of return. The rise in real yields makes the real economy even less attractive to invest in; and also less easy to finance if one is already running a business. Rising real interest rates therefore guarantee that capital will not get invested in the creation of jobs.

The absence of inflation and the risk of deflation will embolden the more “Dovish” members of the Fed to pursue further counter-cyclical inflation policies. Kocherlakota was the first out of the blocks[i]. Having tweaked the “Evans Rule”, to move the unemployment trigger signal for QE exit to 5.5% from 6.5%, he has now also tweaked the inflation trigger. In his latest speech, he called for a removal of the current inflation cap of 2%. He has been careful not to announce what the new level is however; after seeing what happened to JGB’s when the BOJ overtly targeted an inflation number. It seems that the Fed is going to target higher inflation; but is too worried about the bond market risks from being transparent in its communication about what the real inflation target is. Suddenly the Fed is starting to get less transparent again. The risk of course, now is that the market pushes yields higher to see where this inflation target really is. Kocherlakota also cryptically opined that he expects to see more bond market volatility[ii]. Clearly he understands that by not saying where the inflation target is, the Fed will now prompt bond traders to search for it via higher yields.

Pianalto probably deserves the prize for disingenuousness. In her latest speech, she opined that greater transparency of communication had made Fed policy more effective[iii]. She also seems to think that greater transparency equates to greater financial stability. What she overlooked is that this only works, when all the speakers are speaking with the same voice. As has been seen recently, there are increasing voices of dissonance; not only from the Fed but also from other global central banks, which has undermined policy effectiveness. She has also totally missed the point, made by Michael Woodford, that by talking about the exit of QE, the benefits of QE get unwound as markets discount this event[iv]. Her biggest disconnect however, must be her failure to see what happened to JGB yields after the BOJ clearly announced commitment to its 2% inflation target. In this case, transparency was the source of instability.

After the recent backup in yields, institutions have adjusted their commentary to fit this new paradigm. The BIS has taken a leaf out of Kocherlakota’s book; and advised banks to embrace the new volatility[v]. This embrace however can only be made by banks willing to raise equity and strengthen their capital ratios. The comments by BIS spokesman Steven Cecchetti suggest that the BIS is calling for the Normalization in interest rates:

“Volatility per se is not necessarily bad.

Price movements are an integral part of the price-discovery process in financial markets, especially when we are faced with unprecedented events such as exit from the current unconventional stance of monetary policy.

With the outstanding volume of government bonds greater than ever, interest-rate risk is at a record high in most advanced economies.

These losses will be spread across banks, households and industrial firms. Robust balance sheets with high capital buffers are the best way to guard against the possible disruptions.”

The BIS does not opine whether the Normalization is a good thing; it simply opines on how to deal with it. In fact, the BIS pointed to one particular feature of capital flows that will make the volatility worse. In Q4/2012 cross border capital flows in the Eurozone crashed[vi]. Volatility in long term interest rates imposed onto this illiquid situation will only make it worse. The BIS also seems very motivated to outline how banks that fail should be dealt with going forward. Under its new scheme, failed banks will close over a weekend and will be moved into holding companies. Once inside the holding companies, creditors will be written down in order of debt seniority and in compliance with deposit guarantees in effect. The banks will open the next business day and receive emergency liquidity support. They will then be sold at market prices over the ensuing months. This scheme seems to be in direct opposition to the selective “Bail In” models applied in Europe which favour political agendas over creditors. Reading between the lines, it is clear that the BIS sees a coming banking crisis from the Normalization of interest rates. It is staking out its own survival plan; and legal solution for those who don’t survive, well in advance of this crisis.

Janet Yellen seems to subscribe to the BIS view. She may have a specific insight; because it is quite likely that she will be unleashing the next policy initiatives that spook the bond markets. Since banks are still Too Big to Fail, she neatly dodges this iceberg by recommending that they raise capital rather than get broken up[vii]. One suspects however that the banks have missed the boat; and that they will now be trying to sell their shares into a falling equity market.

John Williams also continued to suggest the case for the “Taper” this summer; and perhaps the end of QE purchases by December[viii]. This call was echoed by Goldman’s Hatzius[ix], at Goldman’s “Macro-Conference” in London; where the option to bring forward the “Taper” to September was introduced. It is interesting to note that Goldman had chosen to hold a conference in London on the weekend that the Bilderberg Masters of the Universe were meeting just outside London to settle the big global-macro picture going forward. Goldman doesn’t do coincidences; especially as some of its own people would be at the Bilderberg meeting. Deutsche Bank, the German pretender to Goldman’s global empire, also swiftly followed with its own September “Taper” spin[x]. The matter was settled, when the Fed policy tool known as Jon Hilsenrath reported that the “Taper” announcement will be made at the June FOMC, on the same day that the weak May employment data had pundits convinced that it was off the table[xi]. A pattern is developing. This developing pattern resembles the preparation for the Normalization of interest rates, which was suggested in Terminal Velocity “The Pyramid Scheme”[xii]. In that report we suggested that:

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.

We also asked:

Are we worried?

We are not worried by the Fed. If it did not have a Jeremy Stein, we would be worried. It has a clear strategy and tactical tools in place to deal with the exit of QE; and to adhere to its Dual Mandate in a rising interest rate environment. What worries us is that the Sheep and the Bears in the markets do not understand this “New Fed”, nor are they aware of it. They are still trading headlines and economic numbers. Based on our analysis of Stein and the Sheep and Bears, the only thing to do is to keep buying dips in the equity markets when the Bears create them and the Sheep follow them over the cliff.

Clearly the markets have reached the point at which the Bears are active and the Sheep are following them over the cliff. Thus far, the central banking fraternity has advised the embrace of the volatility associated with this transition to a Normalized interest rate environment. It was therefore interesting to finally hear from a central banker who was attempting to reduce this volatility. The Atlanta Fed’s Dennis Lockhart made a good attempt at softening the interest rate volatility in the Treasury Bond market[xiii]. In his opinion, the economy is still too soft to dial back QE. He also opined that the potential replacement of Bernanke has fortunately not created more volatility; and also implied that Bernanke’s retirement was far from a done deal.

The good work done by Lockhart was immediately destroyed by Richard Fisher, who seems to be intent upon writing a volatile obituary for Bernanke[xiv]. Fisher openly stated that:

“This is the end of a 30-year rally”.

Fisher is at liberty to be inflammatory, because he does not sit on the FOMC this time around. Like minded “Hawks”, currently sitting on the FOMC, must be more circumspect for fear of creating the kind of crisis that will damage their careers. Esther George is one such “Hawk”. Her latest comments would only go as far as recommending a “Taper” if the data supported one; and made it clear that there are fiscal headwinds blowing which present a risk to the “Taper”[xv].

The most interesting notes came from Bernanke himself in his “valedictorian” speech at Princeton[xvi]. Far from being dissonant with Wall Street, they resonated with Main Street. This new resonance suggests a shift in Bernanke’s focus. The economic and financial commentators condescended to make humorous references to Bernanke’s anecdotes; and in their arrogance failed to understand the significance of his words. The pundits and commentators seemed more interested in comparing Bernanke’s Ten Suggestions to Moses’ Ten Commandments. Perhaps Bernanke should have called it a Guide for the Perplexed! When the speech is put into context, it is far less perplexing or amusing.

Bernanke was addressing young Americans, with good educations, who now find themselves going into a workplace that allegedly does not require their skills. We suspect that Bernanke deliberately picked this venue; and delivered a very deliberate message to this demographic with whom he has extreme empathy. His message is therefore something that should have been analysed very closely by the pundits; because it clearly indicates a change in perspective and emphasis from the Fed Chairman. He dropped his guard for once, which he normally holds high for Congressmen and other hostile audiences. What was visible behind the guard was very informative. Should he remain as Chairman, it will be even more important. His message also coincided with a shift in the term structure of interest rates, which should have tipped professional observers that something was going on behind the scenes. Bernanke’s speech was rich in axioms and anecdotes; it was also a very clear signal that he is acutely aware of his obligations to the future generation of America represented by this demographic. He implored them to still see themselves as fortunate and obligated to return something to society. He also apologised for the shortcomings of his own generation and its poor stewardship of America. His apology for his own profession, sought to justify its failings as being the acts of the well intentioned. He said:

“Having given you the essence of sociology and political science, let me wrap up economics while I’m at it. Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much. However, careful economic analysis does have one important benefit, which is that it can help kill ideas that are completely logically inconsistent or wildly at variance with the data. This insight covers at least 90 percent of proposed economic policies.”

These insights are perhaps the most enlightening that Bernanke has made in his career as Fed Chairman to date. He has never been afraid to abandon policies that are inconsistent with the current data; and does not hold with forecasts. He lives and makes policy in the present. Reading between the lines, it is clear that he is having misgivings about the continued adherence to QE. He is also shifting his focus to the younger demographic; and wishes to create a social contract with them. By showing good faith in pursuing policies that are consistent with their future prosperity, he hopes that they will buy into this idea and become reciprocal contributors in their professional lives. In “Fedspeak”, he is now focusing more on the Employment Mandate. Bernanke’s speech was therefore a clear example of his hallmark  transparency; it was also a clear policy signal hiding in plain sight.

Sarah Bloom Raskin provided perfect context to this shift in Fed strategy, when she discussed the state of the Labour Market recently[xvii]. She opined the mismatch between education and jobs available. She also observed the creation of structural long-term unemployment, by the loss of skills and employability which overtakes those who do not immediately find work. Bloom Raskin’s comments follow a direct theme in Bernanke’s Princeton speech. We would advise readers to pay more attention to this theme; and less attention to the dissonance over the “Taper” that the pundits are promoting. The Fed is now interested in creating a new platform for employment creation. Clearly, capital held up in financial assets needs to be encouraged to create employment through capital investment. Low interest rates were thought to do this, but it has now been understood that they only create bubbles in financial assets. True to his word, Bernanke will abandon what has been found to be inconsistent with his mandate. A normal term structure of interest rates and hence normal the pricing of investment risk is needed to stimulate capital investment. Higher interest rates create the reward, which can then be adjusted for the risks being taken to achieve it. A move to this normal structure of interest rates will not be without volatility; so the Fed intends to maintain an expanded balance sheet to absorb much of this volatility (aka the mark to market losses on assets).

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Bernanke and Bloom Raskin’s comments took on an even greater prescience after the Non-Manufacturing ISM was digested by the analysts. The data shows weak growth in the Service Sector accompanied by a large decrease in employment. If these are the kind of “poor quality” jobs that Bloom Raskin was alluding to, they are now disappearing. QE has therefore created ephemeral poor quality service jobs that have no permanence associated with them; and that pay poor wages.

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Further context was provided by the latest Q1/2013 Productivity data. Productivity is falling because Output is falling even faster than the massive fall in Unit Labour Costs.

The speeches by Bernanke and Bloom Raskin appear to be the perfect segways into the poor data that justifies the new direction in policy. The Fed has now got a massive job to do in the real economy; since it has been mistakenly focusing on the capital markets and expecting the bankers to create growth in return.

Jamie Dimon gave the biggest tell, that confirmed the Yield Curve Normalization process when he admitted that he was scared about the prospect[xviii]. Bloom Raskin however took the debate even further. In her speech on Ohio Bankers’ Day, she called for the stricter implementation of the Basel III Rules[xix]. The target date for compliance with Basel III is 2019; however Bloom Raskin wants to start complying now. Clearly she understands that the move to a Normalized term structure of interest rates and normal bank lending will require stronger bank capitalization. The banks won’t be able to make the transition to higher interest rates, which will immediately reduce the value of their current portfolios, without capital buffers. Once having reached the new term structure, they will then need more capital to reserve against these current assets and also to make new loans. Bloom Raskin is therefore suggesting that the Normalization in interest rates must be accompanied by higher capital levels in the banks. To avoid the mistakes of the past, she proposes a more simple approach to bank capital adequacy. Off balance sheet assets must be taken on-balance sheet. Asset risk weighting must be simplified; based on the volatility and price behaviour of the assets, rather than their credit ratings. Simplified leverage ratios must then be applied to these weighted assets.  The mistakes of the past, where some sovereigns were thought to be AAA, until their price behaviour signaled that they were Junk, will therefore be avoided by Bloom Raskin’s regime.

This theme was then expanded by Charles Plosser in his speech entitled “Reducing Financial Fragility by Ending Too Big to Fail[xx]. Plosser suggests a simple solution for the Too Big to Fail (TBTF) question. Banks will be forced to hold more capital, based on rules that govern the ratio of capital to the assets on their books. These ratios will be adjusted for size, volatility and interconnectedness with other banks and asset classes. Banks will also be wound up by judicial bankruptcy process, which takes the issue out of the hands of the FDIC and the White House. Plosser’s solution not only addresses TBTF but also removes the implied Federal Bailout behind American banks.

Clearly there will be some fierce counter-offensives from Wall Street; because Plosser and Bloom Raskin have effectively ended their franchise and bonuses. What they have done is to reinvigorate the TBTF issue and seize the initiative back for the Federal Reserve. The Fed now has a position to defend and to negotiate from. It has also served notice on the banks that they need to get with the programme, because the interest rate term structure is going to ratchet up on them whether they like it or not. To be fair, the American banks are in better shape than the Europeans. However if the Fed delivers on its warning to Normalize, then the volatility in capital markets will force the very solution that Plosser and Bloom Raskin are suggesting onto the global financial architecture. It is now clear where the BIS was coming from, when it opined on this issue prior to Bloom Raskin and Plosser’s speeches. Bloom Raskin and Plosser also confirm our thesis in Terminal Velocity – “The Pyramid Scheme”[xxi] , that the Fed intends to maintain an expanded balance sheet indefinitely. 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.

The rational observer must therefore conclude that the Fed is trying to Normalize interest rates, whilst avoiding another “Credit Crunch”. The “Taper” is actually one of the tools that will allegedly achieve this. As the following graphs show, the rise in US interest rates has been larger than the rise in other global interest rates.

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This suggests that there is a genuine discrete policy Delta being applied by the Fed.

Having identified this transition phase, it is worthwhile speculating about its potential success. Looking at what the BIS and Jamie Dimon have opined, it is clear that a banking crisis is coming; so this transition is not going to be smooth and there are going to be significant casualties. The casualties will be those who have not prepared themselves with strengthened balance sheets and capital reserves. The banks with the largest asset bases relative to the GDP of their countries will be the hardest hit. The first graph in this report (that shows this ratio) suggests that Switzerland, followed by the UK and France will be prime candidates for a banking crisis. Switzerland and the UK have free-floating currencies that can take the strain. France however has a rigid currency and interest rates that are not under its control. France therefore looks like the place to expect the next Cyprus. America looks to be well prepared; which is why capital is currently flowing into its banks.

We believe that the Fed has gone for the transition period now, because the inflation backdrop is low. In addition, its hand may have been forced by the combination of the need to deflate the emerging bubbles in risk assets at the same time that the economic data is deteriorating. The timing is thus not perfect, but the Fed has no choice. The strategic definition of defeat, is being forced to make a move not of one’s choice at a time not of one’s choice by someone else (the victor). The Fed’s QE strategy is a strategic defeat, pure and simple; because it has not created jobs and is now being forced to change by events beyond its control.  To be fair to the Fed however, since it is the only executive body in America trying to do its job right now, we will just say that it has lost the initiative. It is now trying to regain the initiative, by executing a new strategy to create capital investment. As Frederick the Great said,

“It is pardonable to be defeated but never to be surprised”.

It can be also argued that QE saved the economy from something far worse; but since there is no “control” US economy to compare the current one with, this debate is moot.

To apply the analogy from Bernanke’s speech; the Fed has now applied a new strategy that is consistent with its latest data readings. QE provided liquidity to a banking system that had a solvency problem in addition to a liquidity problem. The banking system got over its liquidity problem with QE; and put the excess liquidity from the Fed to work in capital markets, rather than the real economy. Since the economy has not grown enough, the solvency problem has not been addressed. The American economy is not strong enough to pay its legacy debts or to take on additional debt. Now the solvency problem has been compounded by the bubble that the liquidity has caused in risk assets. The Fed is now addressing the “over-liquidity” problem and the existing solvency problem. The liquidity will remain in the system, however it will now be provided with a normalised yardstick by which to value risk and make investments.

Fortunately, as the graph of banking size to GDP shows, 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. From our perspective, the Fed has done nothing about solvency. It is not the Fed’s job to address solvency. This must be done by the politicians and the courts. What the Fed is now doing is forcing the politicians and the courts to deal with the solvency issue. In a Deflation, low interest rates are at least as dangerous as rising interest rates in an Inflation. If it transpires, through this transition phase, that the pain of Normalization in a Deflation is too high we think that the “Helicopter” will make a faster appearance. This Deflation and Normalization will lead to debt liquidations and bankruptcies. The Fed will then come under pressure to create real price inflation. Real price inflation will reduce the burden of debts; and will also create the fake prosperity that people associate with economic growth.

We would not like to speculate on how the market behaves beyond this point; other than to say that interest rates will have a much higher ceiling in the rising inflation environment of the “Helicopter”. We would also use Japan’s recent experience with inflation targeting as a cautionary tale. The Fed may be on the way to a surprise, but it has shown tenacity of purpose in achieving its objective; so it is premature to say that it has been defeated. As Bernanke’s “Eighth Commandment” opined,

“Nobody likes to fail but failure is an essential part of life and of learning. If your uniform isn’t dirty, you haven’t been in the game.”

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