Tag Archives: Federal Reserve

Trumponomics is About to go Global

The critics were wrong and we know this now. On election market futures tanked on the hint that Clinton would lose and Trump might win. They and their pundits assumes that mediocrity and continuation of the Obama polices would permit the investor class to get richer so Trump represented change and risk. Not five hours later the market reverses and streaks ahead.  

Today the market continues to charge ahead. Trump’s election promises of lower taxes, less regulation, less government, seems to be recognized for what it is- a growth agenda. But more importantly, Trump’s winning will result in the export of his policies abroad.

The dollar was already strong against all other currencies. The Fed has no choice but to seek to get to normality with interest rates, and soon. The more the US economy morphs towards higher GDP growth, the more US interest rates will rise. This is a good thing. We need to return to the old normal or an approximation for it.  

But as rates rise so the dollar will surge alongside GDP. As the dollar surges imbalances in exchange rates will lead to two cycles:

  1. Liquidity will center on US and emerging markets and other developed marked will contract as money seeks yield. This will starve other regions of cash. At the same time US exports will be hampered (not overly important to US national economy as a percentage) and for other nations, exports will balloon as their currency is cheaper. The result will be that the US trade deficit will itself balloon again. Inflation will get a fillip due to increased US demand (note that inflation is already showing signs of stability) and as a result, trade partners will suffer greatly under either the weight of their new economic normal (zero rates, no inflation, high relative tax rate, loose monetary policy) being inconsistent with a resurgent US or lack of capital.
  2. As a result, trading partners will need to raise their own interest rates to help stabilize currency markets. This will alleviate some of the dollar’s strength. But if this is the only policy followed, those trading partners will sink into the abyss of stagflation. They will therefore need to emulate many other of Trump’s polices in order to ‘keep up’. So deregulation, lower taxes and more devolved government (perhaps focused on education improvements and local healthcare) will follow.

Trump and his ‘buddy’ Yellen will together export Trumponomics around the world. And it will likely start by the middle of 2017 as the first increase in interest rates in Japan, Europe and/or in some emerging market is triggered.  

The real question though, the real conundrum, concerns China. China is still in a massively debt-fueled growth period and its currency continues to fall against the dollar. Trumponomics will push the Yuan down further and faster, helping Chinese exports to the US. But China will need to raise rates internally, or sell US treasuries (to buy yuan) or buy selling dollars from its massive foreign exchange reserves. Any and all of these will force the Fed to raise treasury yield and rates. Thus the entire cycle that has kept the world economy down for six years will reverse and little will stop it accelerating quickly. It could easily overheat within two years.  

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Near or below zero interest rates do not encourage investment

Central Banks around the world have got it wrong.  During near-normal economic cycles, lowering interest rates altered (through signaling) how businesses funded planned investments.  But those investments are driven by business strategy, not market economics.  Firms are not sitting there saying, “Well, with near zero interest rates- what innovations shall we come up with today?”  Just ask business leaders!

Lowering interest rates just signals a different potential pattern of sourcing of funds, if investments are ready to be funded.  But in this high-regulatory and low-inflation economy, with cheap money funding easy stock buy-backs and a stock market rally, there is no need to innovate as much or make the big or medium size bets that such capital investments need.  Firms are achieving their EPS goals without them.  Just look at the data.
The central bank’s have got it wrong.  Just look at the data.  Capital investment is flat when, according to central bank thinking, it should be ballooning.  Has any central banker actually spoken to any number of business leaders?  Or if so, are they confusing political sycophants for real leaders?

The only way to encourage investment in capital programs for innovation is to return the market dynamics to near-normal settings.  That means that counter intuitively central banks now need to raise rates and curtail quantitative easing.  And quickly.

Why can’t central banks see the obvious?

The problem now is that central banks are looking for even more fuel for the fire.  The Bank of Japan is now reportedly looking at even more extreme measures of the same medicine.  The bond market is about to go the same way as the stock market as in massively distorted.  If we are not careful we will enter the twilight zone and no one will be able to control a thing.

A US Recession Would Require Fed to Raise, not Reduce, Interest Rates

I read with alarm this morning, as I tucked into my poached eggs and sausage at the China World Hotel, Beijing, a CNBC article where a previous Fed economist (Marvin Goodfriend) was quoted as saying the Fed would have to target negative 2 per cent interest rates if the US entered a recession.  See “Why the Fed might need to cut rates to minus 2 percent: Former Fed economist.” 

At this point there are few signs the US will hit a recession any time soon though the US economy is certainly in what might be considered the down-slope from the last growth ‘peak’. Private firms operating margins are being cut which is about the only non-maladjusted metric (as in no government intervention) we can relay on as a sign.  

But Mr Goodfriend’s point is logical: in some of the past recessions the Fed has had to push interest rates 2 per cent below long term rates. As it currently stands the 10 year interest rate is at around 1.5 per cent. So logically we should expect a record breaking negative 2 percent interest rate. But this is not going to work.

At near zero interest rates many ofthe economic and behavioral assumptions related to how the market works are distorted and are not working. If negative or near interest rates were a solution to growth and recovery, why hasn’t the US, UK, Europe or Japan bounced out of the current stagnation? With near zero or negative interest rates there are numerous distortions that suggest more of the same medicine would be, to say the least, daft and ineffective:

  • Private industry does not open up their strategy play-books due to changes in interest rates. Business strategy precedes interest rates. A change in interest rates simply signals to the CFO or Treasurer that there might be alternative funding models for those strategies that need funding. In other words, if there are no strategies for growth, lowering interest rates does not seem to create them. Thus capital investment seems impervious to interest rates at such low levels.
  • Cheap loans fund bad business habits. Where private firms have exploited near zero interest rates is to take out loans to fund both stock buy-backs and fund what I might call non-productive M&A. Stock buy-backs improve earnings per share (EPS) and thus reward executives according to their bonus scheme. But there is no change in the productivity of those firms led by those executives. As such the EPS metric is creating a drug that executives are finding hard to resist but it will rot their, and our, teeth. Second, so much M&A (which is running at record levels), is not actually tied to business strategy developed over time to drive improved performance. So much M&A is short-term or even knee-jerk planning from firms as opportunities to take out a competitor, muddy the market, or upset someone else’s strategy. Thus the companies being acquired are not necessarily sick or struggling. The cheap cash is being used ineffectively and not in accordance with creative destruction.

If you throw on top of this quantitive easing (QE) you can see that the vast majority of the free and cheap money goes to the well-off and investor class and this goes to explain the worsening inequality we see in the US.  And top this lot off with anti-business political policies designed to:

  • Slow growth of start-ups
  • Favor the hegemony of very large, atrophied private business
  • Force direct reallocation of funds to the less well-off versus policy to encourage expansion of employment of the same resources at a more productive and therefore higher paying level

One can see that the current medicine was only good insofar as it stalled the collapse of the financial system some 5 or more years ago. The medicine has gone off; it is now as much a poison to the economy.

Should the US fall into recession the Fed should urgently raise interest rates 2 percent. This will cause the following to happen:

  • Private industry will look at the data and start to behave more logically. Funding choices will start to resemble normal conditions. To grow a business normal business strategy will return to the fore. Capital investment over cheap M&A should start to look more desirous.
  • Stock buy-backs will slow thus forcing a more useful employment of the relatively cheap money. The stock market rally will peak and the economy will start to right itself. Not immediately but over a business cycle money will again flow to firms that grow through innovation and productivity, not intervention and policy.
  • Other sovereign nations will have to respond with similar interest rate increases since the dollar will appreciate rapidly and so the Fed could lead the gradual return to normality around the world.

The challenge will be with government for it will and does today, get in the way. Polices, outlined above, are actually preventing growth. If we don’t remove them, the success of the Fed path, to raise rates to head-off a recession, will be at risk. But this risk is smaller than what will happen if the Fed cuts rates as Mr. Goodfriend suggests.

The Failing Fed?

The US print edition of the Wall Street Journal paints a picture today of the US Federal Reserve as it was a failing institute. The front page carries a leader titled, Fed Stumbles Fueled Populism and it is part of a series called The Great Unraveling. Not exactly an encouraging series title. But the main article is well worth reading. It certainly is fascinating stuff. Two comments quoted express the amazing situation we find our collective selves in.

‘ “I certainly myself couldn’t have imagined six years ago that we would be employing the policies we are now,” Fed chairwoman Janet Yellen said to a packed ballroom in New York earlier.’

This is in reference to near- zero interest rates, quantitative easing and asset purchases that had distorted the market totally.  

‘ “We should be extremely worried,” Harvard professor and former Treasury Secretary Larry Summers said: “We are essentially on a fairly dangerous battlefield with very little ammunition.”‘

This is in reference to the notion that the US economy is very likely passes its ‘peak’ and now moving down towered a ‘trough’. In many years past this should imply a contraction and possible recession. With near-zero interest rates the Fed has no ability to cushion any such contraction and thereby encourage recovery. The Fed can only further increase its balance sheet through new QE or ‘helicopter money’.

Bottom like folks, we are in deep trouble. Of all the economic crises we have seen, from hyperinflation in Germany, the breaking of gold, the inflation of the 70s, the Asian crisis, the recent financial crisis, this is just as risky but for reasons intrinsic to the systems and levers that are designed to avoid such crisis. This is what makes this time different. It is not external conditions that might trigger a crisis; its the very guides that are meant to save us hat might.

And as written widely before, high Fed policies did save the global economy some years ago, such polices had to persist due to the lack of concrete political action. Our political schism has created a void the Fed stepped into. The Fed is now stuck in the resulting mud and has no ability to get out.  

Biting the Hand that Fed Us

Mr. Kevin Warsh, a former member of the Federal Reserve board, now a distinguished visiting fellow in economics at Stanford University’s Hoover Institution, pens a damning Commentary of the Federal Reserve in today’s US print edition of the Wall Street Journal.   

In “The Federal Reserve Needs New Thinking“, he slams the Fed for “….[T]he economics guild push[ing] ill-considered dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. It’s medium term policy objectives are at odds with its compulsion to keep asset prices elevated. It’s inflation objectives are are far more precise than the residual measurement error. It’s output-gap economic models are troublingly unreliable.”

If that were not enough he adds: “And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality.”

Wow- this is a damning perspective from a ex-member of the Fed. I have to say that I tend to agree with his perspective. However the Comment falls short of the title: there is little new policy offering or suggestion to warrant any ‘new thinking.’ The challenge is to query what could or should the Fed and other central banks do differently.
One odd idea I toyed with a few months ago (see The ghost of Keynes haunts our global leaders and economic conditions today) is to globally reset interest rates as if a new normal had been established. What I mean to say is that central banks around the world should all raise their interest rates at the same time by an agreed amount in order to:

  • Preserve current interest rate differential between central bank authorities
  • Establish a more natural rate in order to reestablish normal market and investment operations

If we had nearer-normal interest rates the following would happen:

  • Private capital investment decisions might once again take on a normal demand curve and pattern, thus contributing and steering toward increased productivity
  • The cost of money will rise and so private firms will stop issuing bonds or taking out cheap loans only to increase share buy-backs, thus decreasing the inequality in invest class assets
  • M&A levels would fall to more normal competitive levels
  • Consumers will start to save again
  • Pension funds will have their unfunded portion of their liability reduced

All in all that would be a good day at the office. But it only works if the Fed and central banks in UK, Canada, Europe, Japan, and China agree and collaborate closely.  Additionally the IMF probably needs to leed this effort.

The other problem is the large overhang of debt that central banks now have on their balance sheets. These acquisitions represent government (and some private) debt. These enlarged balance sheets also distort the market. The problem is that central banks have no idea how to jettison these debts without completely upsetting the market again.  

So I guess the only option might be to collaborate with other central banks and agree some kind of normalized write-off. If all central banks agreed to write-off 75% of the government debt they hold, it would free up government spending (since they can start up again, hopefully on the right things this time like education and infrastructure) and the market prices will be balanced. This is of course a silly idea. But how else can we make progress with this challenge?

Yes, new thinking is needed. And a lot more collaboration. The solution will not be found in one central bank. We are too connected. We need a new Bretton Woods 2.0 agreement.

The Next Emerging Bubble (and crisis?) Is Underway

Both the US weekend print editions of the Financial Times and Wall Street Journal reported on what I consider to be the nextfinancial bubble and potential global financial crisis. Let’s ask ourselves – what would the source of the next financial crisis be?

  •  Japan, with its massive public debt that might, should the market ever give up on Japan, swallow up government spending with unyielding interest payments (should interest rates need to be hiked to defend the loss of confidencet in the economy)?
  • Europe, with its weakened and twisted euro, now bereft of the stability of Britain, at the hands of the profligate consumer south of Europe stretching away from the conservative and producer norther states? It maybe the bailed-out Italian banks fall?
  • US, with its “exorbitant privilege” of reserve currency status but with huge watches of government debt held by China, decides to dump it in order to drive the dollar to he floor as a step to push the yuan to reserve status?

No, none of these three challenges are going to blow-up any time soon though they are clear risks. They are all slow burners.  But what might just snap enough to cause a global financial crisis that can overwhelm the monetary policy and reserves of the world? I think it’s emerging markets. 
You see, there is a finely balanced investment model that is ticking and it slips and slides every day – trillions of dollars – and right now the shift is back toward investing in emerging markets.

This is how it works: Yield is globally very low. This is due to (mainly) low and near- or negative interest rates. As such, the trillions of dollars in the world that represents currency exchange combined with hedge fund investments move around the globe daily in search of yield. When the US Fed suggests that interest rates will rise in the US, it is clearly a vote of confidence in the US economy and so funds are attracted toward the dollar. This then puts pressure on the dollar (since everyone wants dollars) and so the value increases with respect to other currencies. This then leads to increased export prices thus depressing US exports. 

But where does that money come from that would move toward the US? The answer is from everywhere around the world and specifically wherever the money is most liquid. Guess what, that means emerging markets. Right now the US is signaling to the market that interest rates are not going to rise immediately, so yield is slightly more attractive in emerging markets. Thus, as the reports in the two newspapers show, funds are flowing freely towards them. This puts pressure on those economies much as the same funds would do to the US. They stoke currency valuation, inflation and weaker exports (over time).  But short term they hep fund construction and keep the recycling of dollars and funds around the world.

As you probably noted in the last two years, as the Fed sneezes with respect to changes in interest rates, even hints of changes to interest rates, trillions of dollars move back and forth between the US and EM in the search for the greater yield.  US interest rates will raise and when they do, the yield will shift to the US.  And we are talking of razor thin margins hence the nervousness of the market.
From the FT article:

  • Equity funds saw inflows of $5.1bn during week ending August 17, the seventh straight week of inflows, according to data from EPFR
  • Over the same seven weeks, a record $20bn was invested in emerging market bonds, with investors taking money out of US and European bonds in favor of the riskier assets

From the WSJ article:

  • The Bank for International Settlements warned Thursday that a corporate-debt binge for emerging-market countries that starts in 2010 is starting to come due now. Between this year and 2018, repayments will total $340bn, it’s estimates show, which is 40% more than during the past three years

Thus the global system of equity and currency trade and investments are finely balanced. Should the dollar suddenly look more attractive, and funds then flow towards the US, at the exact same time as emerging markets need to recycle their debt, there will be a big problem. Emerging markets will have to jack rates up in an attempt to strengthen their currencies which could choke their own growth, thus reducing the markets confidence in them, and so a spiral takes shape – downward. If EM have to jack up interest rates, the US may have to reciprocate. Either way the balance is finely tuned and the great weight of funds will flip-flop between EM and the world supremely quickly. That will create huge complexity and volatility.

Hang on, everyone!

The Relentless Rise of the Dollar and Fall of the Yuan

With sentiment at the Fed shifting toward a rate rise in June, and news today in the Wall Street Journal (see China loses resolve to revamp Yuan) that China is again worried about the pressure on the Yuan, we can all predict what is about to happen. 

The low interest rate the Fed promotes has been described as a response by the Fed to the lack of active policy by the US government to drive economic growth. The market distortion as a result of the low interest rate are frightening. There was a piece, albeit an opinion, in yesterday’s Financial Tines that explained the impact on savings (negative), retirement planning (disastrous), and debt (growing toward all time highs again).   But we will not change the government’s actions overnight, not until November that is, and even that is not guaranteed. So we are stuck between a rock and a hard place. The Fed wants to raise rates but has to avoid chocking off the meager growth that is limping along.

China has its own economic challenges. As it wrestles with the gradual transition from a manufacturing based economy to a consumer and services based economy, it is using the exchange rate to control its export competitiveness. Note that in recent times, in studying the UK’s transition between late 1950’s to the 1990’s, this effort won’t be easy or quick. But China is trying to move quickly, perhaps too quickly.  And despite the IMF signaling it’s faith that China was going to let the market drive the Yuan’s exchange rate, the People’s Bank of China (PBOC) continues to take action to stabilize its currency. 

Assuming the Fed increase interest rates in June, we will all hear that big sucking sound again as capital flies from emerging markets including China back to American shores and the powering dollar. This will trigger a fall in the Yuan and the PBOC will again start to leverage its foreign exchange reserve to stem the losses. That reserve has fallen from an estimated $4th to about $3.2tn in the last year or so. The question is, how far can that reserve go in defending the Yuan?

Sterling was ‘broken’ in the 1970’s and the U.K. Government had to go to the IMF for a loan – check out “Decline to Fall: The Making of British Macro-Economic Policy and the 1976 IMF Crisis, Douglas Wass, 2008”.  That was a low point for the UK. The pound was again ‘broken’, perhaps more famously, by George Soros during ‘black Friday’ when the UK was forced to leave the Exchange Rate Mechanism (ERM), a pegged exchange-rate system that preceded the single currency, the euro. 

Clearly the PBOC won’t use up all its reserves. So the question becomes: what is the level at which the market expects massive red flags? Perhaps a leading indicator to watch are the monthly reported FX outflows from the PBOC. As that ramps up, the red flags will start to fly. And they won’t be the party flags of choice- they will be the economic panic flags that none of us want to see.